Coastal Contracts is expected to have bumper earnings in FY22E-FY23F. We project FY22 earnings to surge by nearly 3-fold, and FY23 to expand by 4% YoY. This is mainly underpinned by new back-to-back contracts for two onshore gas plants at Mexico. In particular, the Papan gas plant contract (EPC and O&M) is valued at a staggering RM4.5bn, and will be recognized over 2022-32. The icing on the cake for FY22 earnings is full-year contribution from a new liftboat. Although FY24 profits will normalize post completion of Papan’s EPC works, the Group’s enlarged profit base is more than double of FY21 earnings. Evidently, Coastal has awakened from its siesta, with new long-term revenues from gas projects at the prolific Ixachi onshore field. Moreover, future earnings expansion is a material possibility. This is because Ixachi’s gas production is expected to ramp up rapidly to reach a peak of 1,100 mmscfd in 2026. As such, the Mexican national oil company, Pemex, requires 3 new gas plants to process Ixachi’s output over the ensuing 25 years. We believe that Coastal is a front runner for these projects, given its proven track record and robust balance sheet. We initiate coverage with a BUY recommendation and target price (TP) of RM2.06 based on Sum-of-Parts valuation.

(A) BACKGROUND

Coastal Contracts (Coastal) was founded in 1976 by Ng Chin Heng, who is currently the Executive Chairman and largest shareholder (indirect interest: 41%). Coastal has nimbly transformed and expanded its business over the years as such: (1) 1976- 1980s: Marine Transportation or vessel chartering, (2) 1990s: Marine Transport and Shipbuilding, (3) 2003-14: Build-and-Sell Offshore Support Vessel (OSV), and (4) 2014-Present: O&G Production infrastructure and assets. The bulk of Coastal’s revenue (1HFY22: 79%) and pretax profits are derived from the Gas Processing segment in Mexico.

(1) GAS PROCESSING

Coastal jointly owns 2 gas processing plants (including one under construction) at Ixachi onshore field in Veracruz, Mexico. Output from the plants is supplied to Mexico’s state-owned petroleum company, Pemex. Both plants are located close to Pemex’s existing gas collection, separation and measuring infrastructure. They are also connected to two major pipelines that transport gas to central, northern and eventually, South East of Mexico.

Ixachi is Pemex’s flagship natural gas development with significant reserves of 1.3bn boe. Discovered in 2017, it is Mexico’s largest onshore discovery since the 1990s. Upon hitting peak production in 2026, it is expected to be Mexico’s highest-producing onshore field.

Meanwhile, the Group’s 50% joint venture (JV) partner is Nuvoil Group, which is an established Mexican-based O&G player. The latter has 23 years track record in Engineering, Procurement, Construction (EPC) as well as Operations and Maintenance (O&M) for onshore gas plants in Mexico. Additionally, the Nuvoil Group is also involved in: (1) oil field operations, (2) natural gas compression, and (3) artificial lift systems.

(i) Perdiz Onshore Gas Sweetening Plant

Perdiz plant (capacity: 180 mmscfd) extracts impurities (ie. condensates) from wet sour gas. This project, comprising EPC works and plant O&M, was awarded by Pemex in Feb-21 and was recently completed in Jul-21. The plant’s RM259mn O&M contract has a firm period of 32 months (end: Feb24) with extension options. Pemex is contractually obligated to offtake minimal volume of 120mmscfd (67% of capacity) from the plant’s output. Nevertheless, actual volumes have surpassed this, as evident from estimated 2QFY22 plant utilization of 84%.

(ii) Papan Onshore Gas Conditioning Plant

In Dec-21, following the success of Perdiz, Pemex awarded a larger project (capacity 300 mmscd) to the Coastal-Nuvoil JV. This contract is valued at RM4.5bn, which comprises O&M over 10 years and EPC works (tenure: 250 days). The latter contract is valued at approximately USD219mn, and comprises related infrastructure such as pipelines, valves, control systems, and civil works. Upon the plant’s completion, Pemex will offtake minimal plant output of 150 mmscfd based on a take-or-pay arrangement. This plant is located nearby Perdiz, and is capable of gas sweetening, dehydration, dew point control, and LPG extraction. The corresponding output is sweet dry gas, LPG and naphtha. Phase 1 and 2 is targeted to commission by Jul and Sept 2022 respectively.

(iii) Agosto 12 Jack-Up Gas Compression Service Unit (JUGCSU)

Agosto (capacity: 200 mmscfd) compresses gas supplied by Pemex at the Canterell field, Gulf of Mexico. This gas is then injected into aging O&G reservoirs at the same field to maintain pressure and enhance oil recovery. Its USD372mn contract (start: August 2016) has tenure of 8 years (firm) + 4 years (options) with Nuvoil Group.

The firm period for Agosto’s bare boat charter will expire by end-Nov 2023. Nevertheless, management is currently negotiating extension terms with Nuvoil. According to management, the extension tenure could potentially stretch 2-3 years. The outcome of these negotiations will likely be revealed by end-22.

(2) SHIPBUILDING & REPAIR

Coastal has two shipyards in Sandakan, Sabah with combined size of 100 acres. However, according to management, the Group is no longer keen on this legacy business. Moreover, Coastal outsources its shipbuilding works to Chinese yards that are more cost competitive. Hence, Coastal is gradually shifting its focus to more attractive projects in other segments. Evidently, in FY20-21, Coastal transferred unsold Offshore Support Vessel (OSV) inventories to its Vessels Chartering division. Thus, this catalysed the Group’s transformation from OSV builder to owner. Nevertheless, Coastal’s shipyard is currently used to berth any of the Group’s idle OSVs. Additionally, the yard is also used for: (1) occasional dry docking works for navy vessels, and (2) fabrication of low-end vessels.

(3) VESSELS CHARTERING

At this juncture, the Vessels Chartering division owns a fleet of OSVs and one liftboat. In 1HFY22, this segment contributed 21% of revenue and pretax losses of RM8mn. Charter contracts for the OSVs and liftboat are secured by a ship management company and a strategic partner respectively.

(i) OSV

Management revealed that it intends to sell off its OSV fleet (Figure 2). This is given that the OSV industry is cyclical in nature and has low barriers of entry. Moreover, short charter contract tenures (maximum: circa 3 years) translate to low earnings visibility. As such, the Group is keener to own other types of O&G assets that are less commoditized.

(ii) Liftboat

Coastal owns 80% stake in a liftboat, Teras Conquest 7 (TC7) that was built in 2015. Meanwhile, the remaining 20% stake belongs to a strategic partner, JUB Pacific Pte Ltd. The latter is a liftboat operator that manages 16 units of liftboats and accommodation rig. JUB has offices in Middle East, West Africa and Asia.

TC7’s current time charter contract with Saudi Aramco will expire by Sept-22. Nevertheless, management is confident of contract renewal due to high demand, particularly in the Middle East. To recap, Coastal acquired TC7 back in Feb-21 for a bargain price of USD13mn. The vendor was Singapore-based Ezion Group that has now been wound up due to insolvency. The cheap acquisition price implies low depreciation costs for Coastal, and hence competitive tender rates.

Liftboats are self-propelled, multi-functional, self-elevating platform-based vessels. It has a large open deck to carry equipment, materials, and supplies. This is to support offshore activities such as construction, equipment installation, maintenance, accommodation and decommissioning. Apart from offshore O&G fields, liftboats are also deployed at offshore wind farms for installation and maintenance works.

(B) GROWTH OPPORTUNITIES

Coastal is keen to bid for new tenders in Mexico, particularly for gas projects where it has successful track record. Additionally, the Group is also open to acquiring additional liftboats in collaboration with strategic partner, JUB. This is for deployment at offshore wind farms to support installation and maintenance services. Lastly, global O&G production assets are also on Coastal’s radar.

(1) OFFSHORE GAS PROCESSING AT CANTARELL

According to management, Pemex requires eight JUGCSU over the next 20 years. However, there are only 2 working units currently, including Agosto 12 and a Spanish-owned unit. On the back of this, Coastal is hopeful to secure more JUGCSU contracts. Additionally, management is confident that ongoing negotiations for Agosto’s contract extension will be successful. Moreover, unlike its Spanish counterpart, Agosto may be easily relocated and hooked-up to other facilities.

(2) ONSHORE GAS CONDITIONING AT IXACHI

Management is eyeing various gas projects for its Nuvoil JV in Mexico too. This includes: (1) Ixachi gas conditioning plant (large), (2) Gas storage project (large), (3) Oil Processing plant (medium), and (4) Gas dehydration plant (small).

According to management, when Ixachi field hits peak production by 2026 (estimate), Pemex will require 3 new gas conditioning plants. This is to process the field’s associated gas output over the next 25 years. During this period, Ixachi’s gas production is forecast to reach as high as 1,100 mmscfd. This exceeds existing and upcoming processing capacity at the field, which comprises Papan and Perdiz (cumulative capacity: 480 mmscfd).

(3) OFFSHORE WINDFARMS IN ASIA

According to the US Department of Energy’s (DoE) 2021 Offshore Wind Market Report (OWMR), Asia is the 2nd largest offshore wind market globally after Europe. Currently, Asia has 7,791MW of installed cumulative capacity. Additionally, in terms of annual capacity additions (Figure 3), the Asian market may soon surpass Europe, driven primarily by China. In particular, Taiwan is expected to tender 2,000MW of offshore wind farm capacity in 2022 (end-20 installed capacity: 128 MW). Moving forward, the Taiwanese government has ambitious targets to reach installed capacity of 15,500 MW by 2035.

Meanwhile, the Vietnamese government is working with the World Bank, Danish Energy Agency, and the Global Wind Energy Council (GWEC) to determine its long-term wind energy goals. The GWEC study recommended built-out capacity of 10GW by 2030, 25GW by 2035, and up to 40GW by 2040. At this point, offshore wind energy could supply 17% of the nation’s electricity demand. Vietnam currently has installed capacity of 99 MW, 539 MW under construction, circa 1,300 MW approved, and 1,200 MW awaiting approval.

(4) O&G PRODUCTION ASSETS

The Group is eyeing medium-sized O&G production assets that have high barriers of entry, with locked-in long term contracts globally. This includes (1) Mobile Offshore Production Unit (MOPU), (2) Floating Production Storage and Offloading (FPSO), (3) Floating Production Unit (FPU), (4) Floating Storage and Offloading (FSO), and (5) Floating Storage and Regasification Unit (FSRU).

According to Rystad Energy, 10 FPSO contracts are expected to be awarded globally in 2022. Brazil is anticipated to award three FPSOs, whilst the UK will likely tender two projects. Meanwhile, Guyana, Angola, Australia, China, and Malaysia are forecast to each award one new FPSO contract in 2022. On the back of this, global FPSO awards in 2022 is expected to maintain 2021’s strong momentum. To recap, 10 FPSOs were awarded in 2021, which translates to a significant improvement versus 2020 (3 units).

(C) FINANCIAL FORECASTS

In FY20-21, Coastal’s earnings (Figure 4) took a hit due to the Covid-19 pandemic. This had affected demand for OSVs as the market slipped into oversupply. The impact was particularly evident in FY21 whereby there were no delivery of vessels from the Shipbuilding & Repair segment. Whereas in the prior year, Coastal managed to sell several low-end vessels. Correspondingly, in FY20, Coastal recognized one-off impairment loss on receivables and write down of inventories amounting to a chunky RM134.5mn. In spite of the above, the Group managed to avert slipping into losses as earnings were anchored by steady contribution from Agosto 7. Additionally, TC7 contributed maiden earnings in 4QFY21.

Nevertheless, from FY22 onwards, earnings will experience a major uplift following Coastal’s transformation and shift in focus to gas processing. We expect profits to almost triple in FY22, on the back of: (1) Papan: maiden 40% progress recognition from EPC contract, (2) Perdiz: full year contribution (FY21: nil) at plant utilization of 80% and estimated tariff of RM1,631 per mmscfd, (3) TC 7: 12 months earnings (FY21: 5-months), and (4) Shipbuilding & Repair: narrowed pretax losses due to new vessel sales of RM110mn announced in Mar-22 (FY21: nil).

Meanwhile, in FY23, we expect profit expansion to moderate to 4% YoY due to a high base effect. Earnings growth is mainly driven by higher 60% progress billings for Papan’s EPC contract (FY22: 40%) as well as maiden contribution from its O&M contract. For the latter, we assume 80% plant utilization at RM2,500 per mmscfd. Meanwhile, we expect Perdiz to achieve stable YoY utilization of 80%.

In FY24, we expect profits to normalize (YoY: -28%) following completions of Papan’s EPC contract and Agosto’s firm contract tenure. As conservative measure, we assume a 30% step down in daily charter rates to an estimated USD66K for Agosto’s new contract extension. Nevertheless, the enlarged FY24 profit base (more than RM80mn) translates to more than 2-fold of FY21’s earnings. This is largely anchored by earnings contribution from Papan and Perdiz at plant utilization of 100% and 80% respectively.

(D) INVESTMENT THESIS

(1) Earnings Growth

As detailed above, we project FY22 earnings to surge close to 3-fold, and FY23 to expand by 4% YoY. Thereafter, FY24’s normalized profit base translates to more than double of FY21 earnings.

(2) Business Expansion

Potential new projects and fleet expansion is underpinned by robust opportunities mentioned above. Moreover, Coastal’s plans to exit the highly competitive and commoditized businesses (i.e. OSVs and Shipbuilding) will remove earnings drag.

(3) Long Term Stable Income from Gas Plants

Papan and Perdiz have short payback periods, whilst Perdiz secured a long term 10-year O&M contract until 2032. Furthermore, recall that Pemex is required to offtake minimal volumes from both plants (Perdiz: 67%, Papan: 50%). As such, this translates to steady earnings with high visibility.

(4) ESG Friendly

The Group’s plans to penetrate the wind energy market is expected to boost its ESG (Environmental, Sustainability and Governance) standing. Moreover, Coastal’s exposure to relatively cleaner gas projects is favourable from the ESG perspective.

(5) Cash Cow Assets

TC7 and Agosto 12’s revenues mostly flow directly to bottomline. This is given minimal depreciation and finance costs. Recall that TC7 was a bargain asset bought at distressed valuations with zero borrowings. Whereas Agosto 12’s borrowings will be fully settled by Dec-22.

(6) Robust Balance Sheet

Coastal is currently in net cash position with chunky cash balance of RM333mn. This provides a sizeable war chest for new projects and expansion. Moreover, according to management, its O&G competitors in the Mexican market face tight lending conditions. Hence, Coastal’s healthy balance sheet provides it with a major edge.

(7) Dividend Upside Potential

Based on historical track record, Coastal’s dividend payout ratio ranges at circa 20%. However, due to the industry downturn, dividends were temporarily suspended. According to management, Coastal is currently in its nascent growth stage. Therefore, the Group may need to preserve cash to invest in new projects during this current industry revival. On the back of this, we have conservatively assumed a payout ratio of 20% in FY22-23. Nevertheless, we believe there is likelihood of higher than expected payout in-lieu of Coastal’s super normal profits during this period.

(E) DOWNSIDE RISKS

(1) Pemex’s Fragile Financial Health

Pemex is the most indebted oil company globally, with USD113bn of debt. Moody’s rates Pemex as Ba3, which is three levels below investment grade, with negative outlook. According to Moody’s, Pemex has weak liquidity and is highly dependent on government support. On the other hand, Fitch rates Pemex as BB- with Stable outlook. Fitch estimates Pemex's free cash flow will average approximately negative USD11bn p.a in 2023-25. This is as the company seeks to increase capex to reverse production decline rate. On the bright side, Fitch believes that the Mexican government will continue to provide meaningful financial support to Pemex if necessary. Evidently, Pemex’s tax rate was reduced progressively from 65% in 2019 to 40% in 2022.

On the bright side, Coastal’s assets in Mexico are working on “easy” oil fields that are shallow water (Cantarell) or onshore (Ixachi). This implies relatively lower costs and fast turnaround time. As such, given that Pemex requires cash flows urgently to service borrowings, we believe such fields will be prioritized. Therefore, this implies accelerated field production and prompt payment to contractors. Evidently, this was the case with both the Agosto 12 and Perdiz projects.

(2) Lack of Execution Track Record for Papan EPC

Given Coastal’s lack of experience with major plant EPC works, this translates to execution risk for the Papan project. Moreover, this is exacerbated by the current inflationary environment that may lead to cost overruns. In particular, this applies to construction materials such as steel and cement. On the positive side, at this juncture, Coastal has secured circa half of its required plant equipment. As such, this partially cushions the risk of price inflation.

Additionally, there is also risk of slow EPC payments by Pemex for Papan’s permanent primary infrastructure. At this juncture, Pemex has merely accepted 2 milestone claims (3% of total contract value) submitted by Coastal. Recall that the plant is scheduled to complete by Sept-22.

(F) ENVIRONMENTAL, SOCIAL & GOVERNANCE (ESG)

We assigned *** ESG rating for Coastal. The Group scored the highest marks for Environmental (E) given its high (85%) revenue exposure in cleaner gas transition assets. According to management, Coastal places high emphasis on sustainability by targeting businesses in gas projects and renewable energy (RE). Evidently, Perdiz, Papan and Agosto are involved in gas production fields.

In particular, Agosto has the ability to compress sour gas for injection into reservoirs at the Cantarell field. This enables enhanced oil recovery which boosts field efficiency. In addition, reduction of gas flaring results in lower Green House Gas (GHG) emissions. Lastly, Coastal targets to deploy TC 7 to service wind farms. Hence, this will accelerate the proliferation of RE in Northeast Asia and the Middle East.

Other significant E initiatives by the Group include:

(1) Coastal sources for fuel-efficient marine engines that comply with nitrogen oxide emission level requirements set by International Maritime Organisation (IMO).

(2) Only non-toxic and non-polluting tin-free antifouling paints are used in the coating of ship hulls.

(3) Manned ships are equipped with energy-efficient bulbs and sewerage treatment systems. This reduces effluent discharge into waterways and the sea.

(G) VALUATION

We value Coastal using Sum-of-Parts (SOP) methodology (Figure 5) to arrive at our target price (TP) of RM2.06. This implies attractive CY22/23 forward P/E of 9.6x/10.9x. In comparison, Coastal’s peers (Figure 6) are trading at 9.1x/11.8x for CY22/23. We believe the slight premium is justified, given its superior balance sheet, and coupled with high growth prospects at Mexico. We initiate coverage with a BUY recommendation.

Source: TA Research - 13 May 2022