We expect SapuraKencana’s E&C, drilling and Brazil operations to continue to perform well despite the challenges in the oil market. Upgrade to BUY (from Neutral) with a higher SOP-based MYR2.51 TP (from MYR1.87, 43% upside). We believe the time is ripe for the company to perform. Little weight should be placed on crude oil price in FY17 as low production numbers would only affect earnings marginally, while FY18 is likely to be the year to look out for.

Share price correlation to crude oil price not justified. For FY17, every 10% increase/decrease in crude oil price would only result in a 0.8% change in earnings due to the low production numbers while in FY18, a 10% movement in oil prices would result in a larger 2% change in earnings. For FY17, we believe more weight should be placed on its engineering & construction (E&C), drilling and its Brazilian operations which are doing well, as well as its energy segment as the production profile starts to climb.

E&C and drilling. SapuraKencana Petroleum (SapuraKencana) started the year with a USD117m contract win for its E&C and drilling segments. This speaks volumes of its ability to win exploration and development jobs even in a market downturn, given its scale and international presence. We are forecasting it to add a further USD450m to its orderbook, which we believe is a very conservative estimate considering that it managed to garner USD580m worth of new jobs in FY16 and USD13bn in FY15.

Brazil. We took a closer look at its Brazilian operations where SapuraKencana, in a 50:50 joint venture (JV) with Seadrill, has won a total of US D3.1bn worth of projects in 2012 and 2013, which is likely to keep the company busy until at least 2027. We value the segment separately with a DCF valuation, coming up with a value of MYR0.37.

Lower earnings have been taken into account. We believe the market has priced in the 27% lower earnings in FY17 due to the cut in production profile as well as the lower crude oil price forecast (to USD37.50/barrel (bbl) from USD50/bbl). We lift our SOP-based TP to MYR2.51 (from MYR1.87) and upgrade our recommendation to a BUY as we believe: i) its E&C, drilling and Brazilian operation would continue to do well, ii) the market has priced in the 27% decrease in earnings in FY17, and iii) negative sentiment on the share price due to a drop in crude oil price is overdone. Potential earnings upside would come from its E&C segment as we are only forecasting a conservative orderbook of an additional USD450m in FY17.

Risks to our earnings. Lower production profile and lower realisable crude oil prices, slower orderbook recognition, and contract cancellation.

Earnings sensitivity to crude oil prices. We did an earnings sensitivity to crude oil prices for SapuraKencana. For FY17, a 10% increase or decrease in the average realisable crude oil price would result in only a 0.8% change in earnings. For FY18, the change in earnings is larger at 2% due to a higher production profile. It is expected to lift 9,000 barrels per day (bpd) in FY17 and 24,000 bpd in FY18. Therefore, the low crude oilprice may only have a slight impact on SapuraKencana’s earnings in FY17. However, as its production profile is expected to climb up from FY18 onwards, only then do we believe that more scrutiny should be paid to crude oil price movements as earnings contr ibution from the energy segment would start to increase. For FY17, we believe more weight should be placed on its E&C, the Brazilian operation as well as drilling segments, as these three segments are driving earnings at this juncture and not its upstream production segment.

Softer energy segment from lower crude oil price. We believe that with SapuraKencana’s production profile as well as with our in house forecast of crude oil prices, its energy segment is worth MYR0.36. Note that we are expecting crude oil price to average USD37.50 per bbl in 2016, USD45 per bbl in 2017 with a rebound to average USD60 per bbl from 2018 onwards. On its gas production, recall that the company had also signed a gas sales agreement with Petronas for the development and production of the SK310 B15 gas field. First gas is expected to be achieved in FY18 with an initial production of 100 million standard cubic feet per day (mmscfd). The shortfall in production levels are due to the exclusion of Vietnam oil & gas fields as SapuraKencana had decided to hand back the fields to Petronas due to the challenging operating environme nt.

We present below in Figure 3 several different crude oil price scenarios. W e are using our house forecast for our base case scenario. For our bear scenario, we are expecting a long term USD40 per bbl crude oil price. For our bull scenario, USD50 per bbl for 2016, USD60 per bbl for 2017 and USD80/bbl for our long term price assumption. For our very bullish scenario, we are expecting a long term crude oil price of USD100 per bbl.

E&C and drilling still stable. Contrary to the bearish sentiment of the oil & gas market, SapuraKencana has been winning contracts for its E&C as well as new charter contracts for its drilling rigs. In FY16, the company added USD530m to its orderbook for its E&C division with projects in Malaysia, India, Mexico, Indonesia and Vietnam. We believe the company’s ability to keep garnering new contracts are due to its global presence as well as its integrated operational capabilities across the service value chain. For its drilling segment, the company bucked the trend of the lower demand for drilling rigs as it managed to secure new contracts for its SKD Esperanza, SKD T20, and SKD Alliance for works in Malaysia and Ivory Coast. Going forward, we are expecting the E&C segment to secure at least USD400m worth of new contracts which we believe is a very conservative estimate.

Significant opportunities for E&C. The main driver for its growth and resilience remains its E&C arm. Looking at its most recent orderbook wins, the company is con centrating its efforts in South-East Asia, India, West Africa, Mexico and Brazil. It is working with the national oil companies (NOC) of those countries and countries within the mentioned regions due to NOCs’ long-term interest and strategic national capabilities. We do n ot doubt that if oil price continues to trend downwards, even SapuraKencana’s E&C arm might be under pressure to win new contracts. However, its secured orderbook amount of MYR21bn would provide the company with a buffer to withstand the downturn until FY19.

Taking a closer look at Brazil. SapuraKencana attracted negative sentiment due to its exposure to Petrobras in Brazil which has been plagued by a corruption scandal as well as a very hevydebt load. As of 3Q15 the national oil company had amassed a total debt of USD128bn with a net gearing of 140%. To recap, SapuraKencana won two contracts to supply six pipe laying support vessel (PLSV) in a 50:50 JV with Seadrill. The first contract is for three vessels worth USD1.4bn for a firm period of five years with an option to extend for another five years. The second contract is for three vessels worth USD2.7bn for a firm period of eight years with an optional extension for another eightyears. Currently, we understand that there are already three vessels in the water with the next three vessels to progressively start in the coming years. With Petrobras being burdened with a huge debt, it is only natural to assume that SapuraKencana’s contracts might be at risk of cancellation or being delayed. However we would like to argue that the PLSV is undertaking a critical part of Petrobras development infrastructure, laying gas and oil pipeline. Without it, the national oil company would have no means of transporting the crude oil & gas from its fields to be monetised. We understand that SapuraKencana has been receiving payment from Petrobras every 30 days for its services which we believe support our view on the critical importance of the pipelines to Petrobras.

What happens if Petrobras reneges? In the event that Petrobras cancels the contract with SapuraKencana, this would result in a loss of MYR135m from its JV contribution line for FY17 and MYR260m in FY18 dragging our PATAMI forecast downwards by 11% and 18% for the respective years. However, we believe this scenario is unlikely as mentioned before as the pipelines are a vital infrastructure for Petrobras, cancelling or delaying the pipelines would affect the monetisation of the oil & gas fields in Brazil. Considering the long period of the contracts, we value the Brazil contracts using DCF and we value the segment at MYR0.37.

Balance sheet and cash flow analysis. We have looked at SapuraKencana’s balance sheet and cash flow coupled with its repayment plans for the next few years, and ran two scenarios to determine its financial position which we showed in Figure 7. Even in the worst case scenario – with no contract wins for E&C, Brazilian operations gets cancelled and oil price stays low for the next five years – the company’s interest coverage is still above 3x. We believe that SapuraKencana would be able to survive the industry downturn, owing to its resilient cash flow as well as a hefty orderbook of MYR21bn which is likely to provide a good foundation for the company to look for new contracts .

Worst case scenario. Our worst case scenario for SapuraKencana assumes several conditions: i) the Brazil contracts gets cancelled, ii) E&C and drilling does not win any new jobs in FY17 and FY18, and iii) oil price stays low at current level for the next fiv e years. This ought to result in a 38% and 57% decrease in earnings for FY17 and FY18. We show in Figure 8 our worst case scenario TP.

Taking into account 27% earnings decline. We believe the market has taken into account the expected lower earnings in FY17 mainly due to the lower average crude oil price as well as the decline in upstream production. We downgraded our forecast for FY17and FY18 by 24% and 15% due to the lower production numbers from our previous assumptions as well as for our downgrade in crude oil price forecast. We do not discard the negative sentiment on SapuraKencana, which is due to the lower oil price and its involvement in upstream production, however we believ e that for FY17 more weight should be placed on its E&C, Brazilian operation as well as its drilling segment which is still performing well and garnering contracts not just in Malaysia but globally. We value SapuraKencana at MYR2.51 (from MYR1.87, 43% upside) based on our SOP-based TP. Risks to our earnings include lower orderbook wins, lower production profile and lower realisable crude oil price. Further upside potential to our earnings include higher realisable crude oil price, higher drilling rigs utilisation, and higher orderbook wins .