After reacting to earnings risk, share price found support based on dividend yield. 2018 is a year of balancing challenging cash flow generation with the need for business growth. Along with expectations of a weak 2Q18, cash flow and dividend have downside risk. We assess this as a minor risk for now, as MISC is guiding for a 10% yoy decline in core US$ EBITDA. Upgrade to HOLD, with adjusted SOTP-based target price of RM5.85 (down from RM6.15), implying 5% yield. Entry price: RM5.20.

WHAT’S NEW

• Key guidance on cash flow, rather than earnings. The group is now guiding for core operating cash flow to decline 10% yoy from 2017’s base of US$1.2b, but will strive to maintain DPS payout (FY16-17: RM0.30). This compares to the previous guidance which was to strive to maintain the US$ profit base yoy. Note that the current EBITDA guidance is in US$ terms and does not include non-recurring items. MISC also guided to commit base yearly capex of US$0.6b (about US$0.2b for drydocking and upgrade capex), while growth capex is another US$0.6b assuming all its targeted contracts are secured (though this would be spread out over a few years).
• New contracts to contribute over the long term. Growth capex includes deliveries of FSO Benchamas 2, one LNG vessel (1H18), 2 Suezmaxes and 4 Aframaxes by 1H19. It also includes the delivery of two 125,000dwt shuttle tankers for Statoil and four 150,000dwt shuttle tankers for Petrobras, all by 2020. MISC targets to replenish earnings for offshore (FPSO/FSO) division by bidding for long-term FSO contracts (capex US$0.1b-0.3b). Without this, offshore earnings will decline as the FSO Abu and Angsi contracts are set to expire. MISC is interested to bid for large FPSOs, including Brazilian projects, though this is not a near-term event until the group has formalised the strategy and risk assessments with potential JV partners.
• Dividends have downside risk, though not significant for now. MISC’s share price had largely reacted to earnings risks since our call downgrade in Apr 18, but has found a support at current levels which implies a 5% yield on a RM0.30 DPS payout. The challenge is on gauging the resiliency of dividends, vs the risk of core EBITDA falling below guidance and if the group chose to focus on growth (higher capex). The cash flow guidance may appear optimistic in view of severe challenges in crude tankers, but 2H18 is widely expected to be a recovery point. Our forecasts are in line with guidance as we factor in a yearly RM3.3b-3.5b capex and -20% growth in 2018 EBITDA forecasts (-10% growth on core EBITDA, another -10% on US$ depreciation factor). In view of this and the low net gearing position, we assess that downside risk on DPS is low for now.

STOCK IMPACT

• Clarity on non-recurring items. MISC further disclosed the following:
  • a) In 1Q18, there were several non-recurring items: ~RM19m impairment of Yemen LNG receivables, US$3m-4m FSO Benchamas 2 construction profits, and a US$7m one-off finance lease adjustment for Kikeh (which is under the JV line). This would adjust core profit to US$87m (reported: US$81m), or RM340m based on our estimates.
  • b) MISC guided for another US$40m-50m of non-recurring items for the remainder of 2018, mainly arising from further Yemen LNG receivables, vessel impairments and finance lease adjustments. Hence, reported profits (on US$ basis) may appear lower vs core performance.
• Tanker may report wider losses in 2Q before a recovery. Given the spot rate movements up until May 18, we believe 2Q18 results (7 Aug 18) may report wider petroleum losses (1Q18: US$18m loss, 2Q17: US$10m loss) assuming similar average rates but with rising bunker prices. This cost upside can be passed through to the charterers, though only partially. The recovery in petroleum strength is only from late-18, as the industry expects tanker supply to rebalance on higher scrapping and lower newbuild activities. A potential uptick in OPEC’s production (reversal in production cuts), and higher US crude exports, are expected to be positive for tanker demand. The rates are still depressed though there has been a slight uptick recently due to a temporary surge in demand for Aframaxes, though still far from profit breakeven (see RHS).
• Other potential long-term income streams are still at work. In the foreseeable term, MISC will continue to focus on boosting its long-term charter mix by securing more shuttle tankers, modular capture vessels and offshore contracts. On the long-term collaboration between Petronas, MISC and Gas4Sea (Engie SA, Mitsubishi Corp and Nippon) for LNG bunkering, the scale and viability of LNG bunkering as a new revenue stream on its own is still being assessed. There may be more new LNG vessel requirements for MISC to support Petronas’ 25%-LNG investments in Kitimat, Canada, though this is not known until a few years down the road.

EARNINGS REVISION/RISK

• Cut 2018-20 earnings forecasts by 8%/6%/6%. We further lower our assumptions on the petroleum division by assuming higher bunker costs and a delay in rate recovery. Essentially, we are looking at a 20% yoy decline in US$ earnings for 2018, and 10% depreciation of US$/RM to 3.9. We forecast an 11% decline in 2018 US$ EBITDA and maintain RM0.30 DPS forecasts, implying 88%/75% of 2018/19 earnings payout.
• Risks: Decline in crude tanker rates. LNG rate renegotiations/terminations.

VALUATION/RECOMMENDATION

• Target price adjusted to RM5.85 (from RM6.15) at implied 15x 2019F PE (in line with 5-year average PE band) and 5.1% dividend yield. We mainly amended the discount rate on DCF (from 7.2% to 8%) in view of the cyclicality of the shipping industry and higher equity market premium, and lower valuations for petroleum in view of wider losses.
• Upgrade to HOLD. The ~15% correction in the share price since our SELL downgrade in Apr 18 has largely factored in earnings risk. However, risk-reward ratio is not yet appealing given more earnings risk in 2Q18, and a minor downside risk on dividends. MISC is encountering a year of a challenging cash flow generation clashing with the need for business growth. 2H18 may be a better investment horizon if petroleum tanker recovers. RM5.20 is a good level to accumulate at implied 15x 2018F PE. However, if cash flow risk is not well contained (ie FCF projections fall way below our forecasts), trough valuation can be RM4.80 on 11.5x 2019F PE, -1SD of its historical mean.

Source: UOB Kay Hian Research - 7 Jun 2018