MISC could see its upcoming 1QFY20 reporting losses due to provisions and impairment expenses resulting from its litigation against Sabah Shell Petroleum over the Gumusut Kakap Semi-Floating Production System. Overall, total damages could result in an 8-9% deterioration of the company’s book value. Nonetheless, earnings should still remain robust at core operating level. Downgrade to MP, with lowered TP of RM7.90.

Possible reported losses in 1QFY20. We have reasons to believe that its upcoming 1QFY20 (results scheduled to be announced on 8 May 2020) could report losses. This is due to huge provisions and impairment expenses being recognised, arising from its litigation against Sabah Shell Petroleum Company regarding the construction and lease contract for Gumusut-Kakap Semi-Floating Production System. The arbitral tribunal issued an award on 8 April 2020 which is unfavourable to MISC.

Summarised back-story: In Nov-2012, MISC was awarded a 15-year firm period contract from Sabah Shell Petroleum Company (SSPC) for the construction and lease of the Gumusut-Kakap Semi-Floating Production System. On 2 Sep 2016, MISC filed against SSPC, claiming for outstanding additional lease rates, payment for completed variation works and other costs. SSPC refuted, and filed a counterclaim for alleged defective work and limited functionality of the Semi-FPS, among other things. And on 8 April 2020, the arbitration award was announced in favour of SSPC. MISC is likely to challenge the award, and is now considering further action.

Impact from the disputes. Firstly, provisions and impairment charges would arise and be recognised in the upcoming 1QFY20 results. This is a result of: (i) restatement of finance lease receivables, as the lease rates will be revised downwards as a result of the arbitration award, and (ii) reversal of previously recognised profits, as the lease is now deemed to have commenced in 2014, instead of the previously recognised 2013. These expenses are expected to drag 1QFY20 well into the red. Secondly, MISC would also be liable to pay for damages of USD325m plus interests and other costs in a worst-case scenario. However, the company strongly believes that it would be able to limit the liabilities to a maximum of USD200m under the contract, and is thus considering to challenging these claims. Both these factors combined, we believe total balance sheet impact could be above USD600m in a worst-case scenario. While net gearing levels would still largely remain intact (0.2x as at end-FY19A), the company’s equity book value may see a deterioration of ~8-9% from FY19A level.

Operational core earnings still robust. Despite the anticipated upcoming reported losses, we believe earnings should still be quite robust at the core operating level. Spot freight rates have surged recently amidst the global shortage of storage spaces for oil, which bode well for MISC’s petroleum segment. Additionally, 4 DPST vessels are also scheduled for delivery in 1HFY20. Meanwhile, its LNG segment should also remain stable as the bulk of the fleet are on long term contracts.

Downgrade to MARKET PERFORM, with a lowered TP of RM7.90 (from RM8.80 previously). To reflect the impending deterioration in the company’s book value, we lowered our ascribed valuation to 1.0x PBV (from 1.1x PBV) – which is already close to +1SD from its 5-year mean (previously at +2SD). However, no changes are made to our FY20-21E core earnings, as the impending provision and impairment expenses would be non-cash and non-recurring in nature, and hence, will eventually be excluded from the core net profit. While we still like MISC for its defensive dividend nature (~4%) amongst the blue-chip counters, our call is downgraded to MARKET PERFORM following the cut in TP. Additionally, the recent low oil prices could also put upcoming tenders (e.g. Limbayong FPSO) into indefinite delays, thereby potentially limiting the counter’s re-rating catalyst. That being said, we believe any significant dips from current levels may present an opportunity for entry as a defence against the weak market sentiment.

Risks to our call include: (i) significantly stronger-than-expected spot rates, (ii) weaker-than-expected Ringgit, and (iii) higher-than-expected number of operating vessels.

Source: Kenanga Research - 27 Apr 2020