Review

• Velesto Energy Bhd (VEB)’s 1H19 core net loss of RM11.2mn (1H18: RM38mn loss, 1Q19: RM23mn loss) was below our expectations and consensus estimates. For FY19, we forecasted profit of RM16mn (consensus: RM25mn).

• The variance was mainly due to lower-than-expected contribution from the HWU fleet, coupled with higher-than-expected finance costs. We expect a stronger 2H19, due to:- (1) 1Q results are seasonally weak due to monsoon season, (2) full fleet utilization in 2H19 except for downtime for Special Periodic Survey (SPS) recertification for NAGA 6 and NAGA 7 (circa 6 weeks), and (3) increased Daily Charter Rates (DCR) of 3%-12% (versus FY18) for NAGA 2,3,5,& 6.

• QoQ, the RM11.5mn core profit in 2Q19, was driven by:- (1) higher fleet utilization and DCRs, (2) decline in net interest costs by circa RM1mn - following early pre-payment of RM50mn debt in Feb-19, (3) contribution from GAIT 1’s new contract, and (4) minimal taxes due to reversal of provision for tax estimates recognized in 1Q19.

• YTD losses improved significantly to RM11.2mn (1H18: RM38mn loss) – mainly driven by higher fleet utilization and DCRs in 2Q19 (average: USD71k). This was underpinned by new long-term drilling contracts with Petronas Carigali following the end of monsoon season. The latter includes contracts for NAGA 2,3 and 5 which were deployed in May-19. Correspondingly, 2Q19 jack-up fleet utilization surged to 74% versus 66% in 1Q19 and 59% in 2Q18 (1H19: 70%, 1H18: 62%).

• Additionally, to a lesser extent, 1H19 bottomline was boosted by:- (1) deployment of GAIT 1 Hydraulic Workover Unit (HWU), (2) breakeven of Oilfield Service (OFS) segment (1H18: RM3.3mn LBT), and (3) lower opex. The combination of the above more than offset drag from higher net finance costs and taxes.

• OFS’ breakeven was driven by a rationalization exercise completed in FY18. Meanwhile, we believe reduced opex was aided by improved terms for new contracts, which includes: (1) less freebies for clients, and (2) mobilization and de-mobilization costs are now largely compensated by the client (rate: 90%-95% of DCR).

Key Takeaways From Analyst Briefing

• VEB proposed an Employee Share Option Scheme (ESOS) program for up to 7.5% of issued shares over a 5+5-year period. This program is expected to be implemented by 4Q19 after securing approvals from shareholders and regulators. Management expects marginal expenses arising from this exercise, which will be charged to Profit & Loss (P&L).

• Currently, there are 20 rigs available in Malaysia, whereby 14 are contracted (utilization: 70%). Out of the 20 available rigs, merely 8 comprises locally-owned rigs, of which 7 belongs to VEB.

• Management is optimistic of rising DCR traction for the latest round of tenders. Regional rates currently range USD80K-100K, whereas in Malaysia, rates have risen in excess of USD80K. Therefore, this implies DCR upside for VEB’s 1+1+1 year contracts with Petronas Carigali. Recall that DCRs for these contracts are negotiated on yearly basis.

• Management is sustaining its strategy to pursue medium term contracts for its jackup fleet. This applies for NAGA 4 and NAGA 8 (expiry: Mar to Apr-20). Recall that other rigs in VEB’s fleet have locked-in contracts until 2022. For NAGA 4, management is currently in talks with ROC Oil for its contract extension.

• Given that the bulk of VEB’s fleet are fully deployed, management is exploring the option of chartering 3rd party rigs if VEB secures new contracts. Nevertheless, for Petronas contracts, VEB will need to bid via open tender for such rigs because Petronas only prioritizes local rigs for direct contract negotiations.

• Management is mulling over the following arrangements if it engages 3rd

party rigs:- (1) VEB receives agent commission fees from rig owner, (2) VEB manages the contract, or (3) VEB manages the rig. The 3rd party rig will be hired on time charter for (1) & (2) and on bare boat basis for (3).

• Management is optimistic of improving prospects for its HWU fleet given rising Plugging and Abandonment (P&A) activities in Malaysia. This implies copious room for improvement, given current low HWU fleet utilization of 25%.

Impact

• For FY19-21, we raise our tax rate assumption higher based on management’s refreshed guidance. Other changes to our forecasts include:- 1) FY19: raised finance rates and reduced HWU fleet utilization, and 2) FY20-21: lowered daily operating cash costs – to correspond with 1H19 run rates, and because our previous assumptions were too high.

• As a result, our FY19 earnings estimates are lowered to RM10mn (previous: RM16mn). Meanwhile, our FY20-21 forecasts are reduced by 4%-6%.

Valuation

• Our target price (TP) for VEB is raised to RM0.38 (previous: RM0.34) based on unchanged 13x CY20 EV/EBITDA. The increase in TP is due to higher FY20 EBITDA generation as mentioned above.

• We believe VEB’s earnings will turnaround in FY19 – driven by improved drilling fleet utilization (FY19E: 79%, FY18: 73%), and uptick in DCRs. Furthermore, earnings visibility has improved, given longer contract tenures for newly secured drilling contracts,

• We expect higher fleet deployment, including for VEB’s Hydraulic Workover Units (HWUs). This is underpinned by increased requirements by Petronas, as stated in its Activity Outlook 2019-21. For 2019, Petronas requires 16-18 jack-ups, whilst 2020-21 requirements would likely increase. This is a significant improvement versus 4Q18 where there was merely 9-10 jack-ups deployed locally.

• To recap, in Apr-19, VEB secured 4 drilling contracts for its jack-ups (totalling USD104.6mn (including extensions) from Petronas. Each contract is on long term basis of 1+1+1 year. Previously, the same fleet was chartered out on per well basis, whereby each well requires approximately 1 month for drilling works to complete.

Source: TA Research - 3 Sept 2019