VELESTO’s 1HFY23 results tracked our expectations but disappointed the market. Its 1HFY23 EBITDA margin was subdued at 27% in spite of the surge in DCRs to USD90k, vs. 49% in FY19- 20 (average DCR: USD70k). This alludes to margin compression amidst an inflationary environment. We maintain our forecasts, TP of RM0.19 and UNDERPERFORM call.

Met our expectations but underwhelmed consensus. Its core net profit of RM30m came in within our expectation at 49% of our full-year forecast but disappointed the market at merely 34% of the full-year consensus estimate.

Sustained recovery in DCRs and demand. YTD topline more than tripled YoY on the back of recoveries in: (i) jackup fleet utilization to 89% (1HFY22: 40%), (ii) rig daily charter rates (DCR) to USD90k (1HFY22: USD75k), and (iii) deployment of hydraulic workover units. Additionally, revenues were also boosted by progress for new i-RDC (integrated rig, drilling and completion) contracts.

On the back of the above, VELESTO was able to turn around from 1HFY23 core losses. This more than offset drag from increased finance costs as well as higher effective tax rate and depreciation. We attribute the latter to implementation of a new Enterprise Resource Planning software system.

On a less encouraging note, in spite of multi-year high DCRs, its EBITDA margin was relatively subdued at 27% in 1HFY23. In comparison, pre-pandemic quarterly EBITDA margins averaged significantly higher at 49% back in FY19-FY20. This was whilst quarterly DCRs averaged lower at USD70k (1HFY23: USD90k). Hence, we believe this alludes to margin compression amidst an inflationary environment globally.

Slight fall in QoQ fleet utilization. DCRs continued to surge, to a high of USD94k in 2QFY23 (1QFY23: USD86k). This translates to its highest level since its most recent trough of USD53k in 1QFY21. Hence, this enabled VELESTO to deliver higher sequential profits (+20%) in spite of lower fleet utilization of 88% (1QFY23: 90%).

Expectations need to be levelled. Given yet another set of soft earnings, we do not discount the possibility of another round of steep earnings cut by consensus. Recall that this was the case post release of 1QFY23 results, when consensus downgraded VELESTO’s FY23F and FY24F earnings by circa 30% and 40%, respectively. Therefore, in spite of a robust outlook for drilling fleet utilization and DCRs, we believe that investors will remain cautious of weak earnings delivery due to opex drag. Therefore, at this juncture, we prefer to stay on the sidelines until cost headwinds dissipate.

Meanwhile, regional DCRs and demand for jackups remain robust on the back of spillover demand from mega multi-year, multi-rig tenders in the Middle East. According to Westwood Riglogix, contract tenures for outstanding tender and pre-tenders in the Persian Gulf have snowballed to 29 years currently. Against this backdrop, day rates in the Persian Gulf region (late-May average: USD109k) are expected to sustain their upwards trajectory. This is further boosted by tight supply, as evident from escalated global marketed jackup utilisation of 92% currently.

Forecasts. Maintained.

We also maintain our TP of RM0.19 based on 15x FY24F PER. This is in-line with ascribed valuations for local-centric service providers within our coverage (i.e. DAYANG). There is no adjustment to our TP based on ESG given a 3-star rating as appraised by us (see page 4).

We prefer to avoid VELESTO due to: (i) costs inflation that may lead to sustained margin pressure arising from higher manpower and materials costs, (ii) catalysts have already played out (i.e. rebound in rig fleet utilization and DCRs), and (iii) the current high interest rate environment translates to earnings drag from escalated financing costs. Maintain UNDERPERFORM.

Risks to our call include: (i) fleet expansion via acquisition of new jackup rigs, (ii) inflated DCRs as jackup market tightens further, and (iii) topline boost from a strong USD/MYR.

Source: Kenanga Research - 30 Aug 2023