- We downgrade our call on Malaysia Marine & Heavy Engineering Holdings (MMHE) to SELL from BUY, with a lower fair value of RM3.00/share (from an earlier RM4.30/share), based on a rolled forward FY15F PE of 25x. This stems from a cut in MMHE’s FY14F-FY16F earnings by 44%-50% due to a 3ppt-4ppt decrease in our operating margin assumption to 4%-7% and 20%-60% reduction in new order intake to RM1bil-RM3bil.

- The margin compression stems from the management’s change in accounting policy for engineering, procurement, construction and commissioning (EPCIC) projects to incorporate completion risk due to increasingly more complex projects. This translates to a more conservative profit recognition standard for MMHE’s current and future jobs, which back-loads earnings towards their completion stage.

- This involves using the least squares regression methodology (see Chart 5) in addition to the group’s current progressive threshold completion policy, which is now applicable for lumpsum projects.

- Hence, MMHE’s 1HFY14 net profit of RM74mil came in way below expectations, accounting for just 29% of our earlier forecast of RM257mil and 32% of street’s RM227mil. The group did not declare any interim dividend as expected.

- MMHE’s 2QFY14 EBIT margin halved to 2.4% as pre-tax profit declined by 25% QoQ to RM26mil despite a 46% revenue surge from the completion of the FPSO Cendor and Tapis-R together with maiden contribution from project SK316.

- While we expect some variation orders of up to RM100mil from FPSO Cendor and Tapis-R to translate into lumpy earnings in 2HFY14, the remaining 2 major projects – Malikai tension leg platform and SK316 central processing platform (CPP) projectsare unlikely to generate significant profit contributions for the rest of this year to early FY15F, due to the group’s more cautious accounting policy. Likewise, even if MMHE secures additional jobs by the end of this year, the new orders will not significantly improve the group’s profit prospects in FY15F.

- With overall yard utilisation at 50% currently and its order book declining by 19% QoQ to RM1.8bil, we expect MMHE to secure new orders from Petronas, such the Kasawari CPP and jackets for the Bergading and Bardegg2-Baronia CPPs. But this is offset by a more lumpy earnings visibility arising from the accounting changes, coupled with clients’ persistent rollout delays.

- The group has lowered its new order intake target from RM3bil since earlier this year to just over RM1bil by the end of the year, highlighting Petronas’ slow order rollouts due to increasingly more complex projects. Management also affirmed that the margins for future projects – already around 10% currently – will come under increasing pressure due to the presence of foreign bidders.

- After our earnings forecast cuts, the stock now trades at a pricey FY15F PE of 30x – 11% above SapuraCrest Petroleum’s 2007 peak of 27x.

Source: AmeSecurities