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Yes, even after the rally.
The demerged Sembcorp Industries (SCI) is currently being valued at CLOSE TO A THIRD of what global peers are trading at.
Do also check out our more updated articles on Sembcorp Industries (SCI).
- 15 July 2020: “[Update] Sembcorp Industries is still DARN CHEAP”
- 8 September: 2020: “[Update] Sembcorp Industries shareholders are going to receive Sembcorp Marine shares – What to Expect + What to Do”
DISCLAIMER! IQ bought Sembcorp Industries (SCI) on 11 June, and averaged down on 30 June and 21 July 2020. The position was sold on 16 September 2020. For the period between 11 June and 16 September 2020, SCI (and the SMM shares received) had outperformed the STI Index by 12%.
PLEASE NOTE! We will use the term “demerged SCI” to refer to Sembcorp Industries (SCI) without its Sembcorp Marine (SMM) stake. We will use “demerged SCI” to talk about historical performance (before the actual demerger) and future forecasted performance (after the demerger).
SCI has two parts: 1) SMM stake and 2) the demerged SCI.
Most commentary has been focused on the current Sembcorp Industries (SCI) and on Sembcorp Marine (SMM), but we haven’t seen any extensive analysis into the demerged SCI. So we took a look ourselves. If you need a primer on the demerger, head down to APPENDIX 2.
1) We look at the demerged SCI’s earnings
Demerged SCI’s Earnings per Share to be around S$0.17 for FY2020
2) We look at the demerged SCI’s implied price
The implied price of the demerged SCI works out to be S$0.68 to $0.85 per share, based on our assumptions as well as the current prices of SCI and SMM.
3) We look at demerged SCI’s valuation and compare it to peers.
At 5.1x forward P/E and 0.47x P/B, the demerged SCI would be at almost A THIRD of what peers are trading at.
Is S$0.85 price for demerged SCI cheap or expensive? We believe VERY CHEAP.
THE INVESTQUEST’S VIEW: What should SCI be trading at now? In our view, S$3.31 to S$3.48 depending on the number of SMM shares received. That implies a 67% to 76% upside against today’s closing price. See below for our assumptions.
- For demerged SCI: S$2.18. Assuming the demerged SCI’s P/E rerates to the peer median of 12.8x, SCI’s demerged 2020 EPS of S$0.17 would imply a fair value of S$2.18.
- For SMM shares to be received: S$1.13 to S$1.30. Each SCI share is entitled to receive 4.27 to 4.91 shares of SMM post the rights issue. At a Theoretical Ex-rights Price of S$0.264, SCI share holders will receive between S$1.13 to $1.30 value in SMM shares.
- We sum the two components above.
THE INVESTQUEST’s CONCLUSION: We find the valuation of the demerged SCI wildly attractive! It’s rare to find such an established player (especially one that is 49.5% owned by Temasek) trading at such low valuations. All our analysis used SCI’s price post-rally — we still see a lot of upside left. We have just bought SCI on 11 June and will continue to buy the stock in the following days.
1) We look at the demerged SCI’s earnings
CONCLUSION: We estimate the Demerged SCI’s Earnings per Share to be around S$0.17 for FY2020
To get to this earnings number of S$0.17 for FY 2020, we used SCI’s consensus earnings and subtracted its share of the SMM’s consensus earnings.
In the table below, we stripped out SMM’s business from each line item to get a picture of how demerged SCI has been doing historically and is expected to do given forecasts for earnings by analysts.
For ease of reference, we will shorten “demerged SCI” to “DSCI” in the table below.
Accounting note 1: Because SMM is a subsidiary of SCI, when SCI presents its income statement, 100% of SMM’s revenue/gross profit/assets/etc. are added to the revenue/gross profit/assets of the other SCI segments.
Accounting note 2: For net income however, SCI has already adjusted for the 39% of SMM that it does not own. This is done by subtracting what is called “Non-Controlling Interests” (see SCI’s annual report). As such, to calculate DSCI’s net income, we minus off only 61% of the reported SMM’s net income, not 100%.
Accounting note 3: To get to DSCI’s “Profit attributable to owners of the company,” we need to subtract 1) Exceptionals (as found in SCI’s annual report), 2) interest income SCI would lose after the transaction, and 3) profit attributable to perpetual security holders.
Accounting note 4: The “interest income SCI would lose” refers to the 3.55% interest cost SMM currently pays to SCI for its S$1.5bn from SCI. After raising cash from the rights issue, SMM will pay off this loan to SCI. Wait, can’t this cash be used to earn interest income elsewhere? Not really. We estimate that the bulk of this cash will be used to replenish what SCI would have to spend to subscribe to the rights issue in the first place.
Accounting note 5: Note that for Exceptionals and the relevant interest income, we have already adjusted these figures for SCI’s 61% shareholding in SMM.
Accounting note 6: The DSCI will no longer have perpetual securities by the end of 2020.
Accounting note 7: How can I reconcile your numbers with the PATMI number that SCI gave in its announcement (SS$296-293m, pg 23) for the demerged SCI? Take the FY19 DSCI Net Income of S$331m and subtract the profit attributable to perp holders of S$36m, you get S$295m. We still prefer to use our numbers (red rows) since we’ve stripped out exceptional items.
Observation 1: For demerged SCI, profitability and gross margins have been stable since 2013. We plotted the revenues (red column), gross profits (blue column) and gross profit margins (grey line) of demerged SCI in the chart below for the period between 2013 to 2019, with consensus forecasts for 2020 to 2021. We observe that gross profits have been growing annually since 2014 and margins have been fairly stable.
Observation 2: For demerged SCI, core net profits excluding exceptional items (red column below) ranged between S$300m to just over S$450m per year, implying earnings per share of S$0.17 to S$0.25 between 2013 to 2019 (grey line in chart below).
Observation 3: Regarding demerged SCI‘s business outlook, SCI gave a relatively bleak outlook in May, warning that performance of its energy business would be markedly lower than last year due to reduced demand and falling prices. The company stated that power demand in Singapore, India and Britain declined by about 10 to 25 per cent last month, compared to the same period a year ago. However, operating cash flow is still expected to remain positive.
2) We look at the demerged SCI’s implied price, given SCI’s & SMM’s current share prices
During complicated corporate actions which are difficult for the person on the street to understand, it is possible for wild underpricing to occur.
To find if this is the case here, we need to know what’s the implied price of the demerged SCI.
CONCLUSION: The implied price of the demerged SCI works out to be S$0.68 to $0.85 per share, based on our assumptions, as well as the current prices of SCI and SMM.
Here’s an easy step-by-step calculation of how we got to the conclusion above.
2A) First, what’s SCI current price?
As of today’s close, SCI is trading at S$1.98.
2B) Second, how much should we value the SMM shares that SCI is going to give shareholders?
STEP 1) The number of SMM shares. Pending AGM approval, 1 SCI share will “give” you between 4.27 to 4.91 SMM shares.
STEP 2) The price of each SMM share, ex-rights. For this we have a few options. The lower a price we ascribe to these SMM shares, the more conservative we are.
- The announced “Theoretical Ex-Rights Price (TERP)”: S$0.308 (as announced in SMM’s SGX press release). This is based on adjustments made to SMM’s 3 June closing price of S$0.85.
- Our adjusted “Theoretical Ex–Rights Price (TERP)”: S$0.264 (our calculation). Unlike the above, instead of making adjustments of SMM’s 3 Jun closing price, we made adjustments to SMM’s 11 Jun closing price which is much lower…
- “Rights Exercise Price”: S$0.20 (as announced).
For our analysis, we’ll be using S$0.264 per SMM share. In our opinion, using the S$0.20 Rights Exercise Price would be a crazily conservative assumption. The Rights Exercise Price is at a 35.1% discount (a steep discount!) to SMM’s announced TERP. This steep discount was intentional — to entice SMM shareholders to subscribe to the deal, as investors would generally subscribe to the rights with the expectation that the TERP is HIGHER than the rights price.
STEP 3) For value of SMM shares received, we multiply “No. of SMM shares received” by “Ex-rights price”. The value ranges between “4.27 shares x S$0.264″ and “4.91 shares x S$0.264”. So each SCI share entitles to you receive between S$1.13 to S$1.30 estimated value of SMM shares.
2C) Third, take SCI’s share price and subtract the value of SMM shares you expect to receive
The answer will be the implied price of the demerged SCI per share. Remember, the number of SCI shares doesn’t change with the above-mentioned corporate actions.
Calculation: It’ll be a range between (S$1.98 – S$1.13) and (S$1.98 – S$1.30).
The implied price of the demerged SCI works out to be S$0.68 to $0.85 per share.
3) We look at demerged SCI’s valuation and compare it to peers
Above, we found that the implied price of the demerged SCI works out to be S$0.68 to $0.85 per share.
In our analysis below, we will use the higher price of S$0.85 to be conservative.
CONCLUSION: At 5.1x forward P/E and 0.47x P/B, the demerged SCI would be at almost A THIRD of what peers are trading at. Based on our list of peers below, the median of those peers are trading at 12.8x forward P/E and 1.4x P/B.
Below, we walk through how we got to the conclusion.
3A) What’s the P/E and P/B at S$0.85?
At S$0.85, what’s the Price-to-Earnings (P/E) of this demerged SCI? 5.1x. In section 2 above, we found that the earnings per share of the demerged entity was S$0.17. So S$0.85 divided by S$0.17 is 5.1x P/E.
On the demerged SCI P/E trend below, some may ask — why has this P/E been trending down and why should the demerged SCI rerate to peers? We would like to highlight three factors: 1) The market typically ascribes a conglomerate discount for “mixed” businesses 2) SMM’s challenging results were a drag on investor sentiment 3) As there has been talk of SCI privatizing SMM (which as we now know is not going to happen), there was always the risk of fundraising and this depressed the share price. In the case of a demerger, these factors will be absent.
Note 2: For the Forward P/E, we use a market cap determined by the implied price of the demerged SCI (S$0.85 x no. of shares). We use the future forecasted and adjusted earnings as discussed in Section 2.
Source: Bloomberg and Sembcorp Industries Annual Reports, retrieved 11 June 2020. IQ Computations.
At S$0.85, what’s the Price-to-Book (P/B) of this demerged SCI? 0.47x.
On the demerged SCI P/B trend below, some may ask — why has this P/B been trending down and why should the demerged SCI rerate to peers? Our answer is the same as above. We would like to highlight three factors: 1) The market typically ascribes a conglomerate discount for “mixed” businesses 2) SMM’s challenging results were a drag on investor sentiment 3) As there has been talk of SCI privatizing SMM (which as we now know is not going to happen), there was always the risk of fundraising and this depressed the share price. In the case of a demerger, these factors will be absent.
Note 2: For the Forward P/B, we use a market cap determined by the implied price of the demerged SCI (S$0.85 x no. of shares). We then compare that market cap to the Demerged SCI’s book value in FY19 (which we calculated and which matches the pro forma book value in the announcements) and then minused off S$1.5bn that is lost in assets because SCI is giving out its subscribed shares. We have also accounted for the current shares that SCI owns for SMM that it is giving out.
Source: Bloomberg and Sembcorp Industries Annual Reports, retrieved 11 June 2020. IQ Computations.
3B) How does this compare to peers?
At 5.1x forward P/E and 0.47x P/B, the demerged SCI would be at almost A THIRD of what peers are trading at. Based on our list of peers below, the median of those peers are trading at 12.8x forward P/E and 1.4x P/B.
SCI’s ex-SMM dividend yield assumes dividend per share of $0.05 is maintained, divided by $0.85 implied SCI (ex-SMM) market price.
SCI’s ex-SMM net debt to equity is computed using projected net cash divided by demerged entity’s NAV, extracted from https://links.sgx.com/FileOpen/SGX%20ANNOUNCEMENT%20FINAL.ashx?App=Announcement&FileID=616791
Furthermore, DIVIDEND YIELD may go up! Given that operating profits for SCI are derived mainly from its non-SMM business, we assume that the demerged SCI can maintain its S$0.05 dividends per share. Dividing that against the implied demerged SCI price of S$0.85, we get a 5.9% dividend yield. This would bring SCI’s dividend yield more in line with global peers.
Is S$0.85 price for demerged SCI cheap or expensive? We believe VERY CHEAP.
THE INVESTQUEST’S VIEW: What should SCI be trading at now? In our view, S$3.306 to S$3.476 depending on the number of SMM shares received. See below for our assumptions.
- For demerged SCI: S$2.18. Assuming the demerged SCI’s P/E rerates to the peer median of 12.8x, SCI’s demerged 2020 EPS of S$0.17 would imply a fair value of S$2.18.
- For SMM shares to be received: S$1.13 to S$1.30. Each SCI share is entitled to receive 4.27 to 4.91 shares of SMM post the rights issue. At a Theoretical Ex-rights Price of S$0.264, SCI share holders will receive between S$1.13 to $1.30 value in SMM shares.
- We sum the two components above.
THE INVESTQUEST’s CONCLUSION: We find the valuation of the demerged SCI wildly attractive! It’s rare to find such an established player (especially one that is 49.5% owned by Temasek) trading at such low valuations. All our analysis used SCI’s price post-rally — we still see a lot of upside left. We have just bought SCI on 11 June and will continue to buy the stock in the following days.
7) Key risks to our view
- We assume that the rights issue and demerger will be approved by shareholders during the EGM scheduled for late August / early September. If they aren’t approved, our analysis won’t apply.
- SCI and SMM are expected to report 1H2020 interim earnings on 14 August and 7 August respectively. Any negative news disclosed may have an impact to our above conclusion.
- In May, SCI told analysts of a challenging outlook due to falling demand for power usage, potential divestment loss in 3Q2020 from a water-related business in Chile, loss of contributions from divested assets and the absence of one-off income in Myanmar. We have used consensus earnings which should have been adjusted by analysts for the outlook. But if there is a negative surprise, net profits may fall more than what the market is expecting.
- Post the demerger, SCI’s leverage will be high. Total borrowings are projected to decline by S$2.9 billion, leaving SCI with debt of S$8.7 billion (found on page 10 of their demerger presentation), or net debt of S$7.3 billion. Assuming $0.85 implied market price for SCI’s demerged shares, SCI’s market cap would only be S$1.5 billion in contrast.
- Dividend per share (DPS) may be reduced to pay down debt. As a continuation to point #4, SCI’s demerged entity will be straddled with a high debt load. The company may decide to trim its dividend to reduce their debt burden.
APPENDIX 1: Calculation of the Theoretical Ex-Rights Price
APPENDIX 2: Background to the Demerger
Recap of SMM’s Rights Issue and SCI’s Demerger
On 8th June, Sembcorp Industries (SCI) and Sembcorp Marine (SMM) jointly announced a corporate action involving two parts, subject to shareholder approval scheduled for late August / early September. For now, no action is required from both SCI or SMM shareholders until the shareholder EGM (extraordinary general meeting). In summary, the details of the corporate action incude:
- Sembcorp Marine (SMM) will launch a rights issue to raise S$2.1 billion.
- Shareholders of SMM will receive 5 rights for every share of SMM owned. For example, if you own 1,000 shares of SMM, you will receive 5,000 rights.
- S$0.20 Rights Exercise Price: Each right will give the owner the opportunity to buy an extra share of SMM at $0.20 per share.
- Alternatively, rights received may be sold (or bought) on the Singapore Exchange similar to how a stock would trade. The trading period will only be confirmed after shareholders have approved this corporate action.
- Use of proceeds: S$1.5 billion will be used to pay back debts owed to SCI and S$0.6 billion will be used for general corporate purposes.
- Sembcorp Industries (SCI) will undergo a demerger with Sembcorp Marine (SMM)
- SCI currently owns 61% of SMM.
- If you are a shareholder of SCI, you will receive between 4.27 to 4.91 shares of SMM, for every 1 share of SCI that you own. The range of 4.27 to 4.91 is to account for the scenario that some existing SMM shareholders may not want to subscribe to the rights, in which case SCI and Temasek will subscribe to the excess rights. The more excess rights that SCI subscribes to, the more shares that SCI shareholders will receive.
- After the demerger, SCI will no longer have any ownership stake in SMM, as this stake would have been transferred over to SCI shareholders directly.
Recap from perspective of a SMM shareholder
A rights issue is definitely negative, especially when compared to an alternate scenario of a privatization event. SMM’s debt levels are on the high side (close to S$4.7 billion in debt with interest expenses of over S$120 million in 2019), while the company is not expected to return to profitability till at least 2021. As a result, the company’s best option right now is to raise cash to reduce debt and ease liquidity concerns.
SMM shareholders will be receiving 5 rights for every share of SMM owned.
The most important thing is to remember to either 1) sell your rights when it is open for trading subsequently or, 2) subscribe to the share rights by paying $0.20 per right. Under no circumstance should you let the rights lapse, as you would have gotten your ownership stake in SMM diluted without receiving any compensation.
Recap from the perspective of a SCI shareholder
You will be receiving between 4.27 to 4.91 shares of Sembcorp Marine for every share of Sembcorp Industries that you own. You need not pay any cash to receive these shares.
This should be viewed as a good outcome, as you would now hold both Sembcorp Industries and Sembcorp Marine shares. This gives you flexibility to sell either part of Sembcorp’s business which you think might not perform.
Separately, conglomerates tend to trade at a discount to the sum of its parts. With the demerger, Sembcorp Industries (which is a conglomerate) might potentially see a positive rerating in valuation, especially since it will no longer have the drag from the Offshore & Marine business which might have deterred investors from buying SCI shares previously.
Demerged SCI will focus on Energy Generation, Waste Management and Urban Infrastructure
Since the oil crash of 2015, SMM has been a drag to its parent SCI, contributing with a 5-year cumulative net loss of S$162 million and negative free cash of over S$500 million.
The potential demerger opens up the opportunity to invest in SCI’s non-Marine business on a standalone basis. The non-Marine business lines include Energy Generation, Waste Management and Urban Infrastructure projects. These businesses interest me because they offer more stability in terms of revenues, profits and cashflows, as we shall see later.
Thank you for the detailed report
glad you found the article useful Jagdish!
Hi Invest Quest,
Thanks for the detailed analysis but i would like to play the devil’s advocate to your otherwise, well written view.
Firstly, I don’t think SCI should be valued on PE, given that ROE growth varies significantly, and hence, a better framework to value Utilities player should be look upon from a PB/ROE perspective, where the underlying g is assumed to be sustainable.
Secondly, I am also puzzled by the selection of peers, which in my opinion, are not fair comparison to SCI. Your selected peers are largely in Developed Markets, and they are generating >10% ROE, while SCI’s largest exposure is in India, and they are facing payment collection issues. Even though ROE for De-merged SCI may normalized at 8%, the cash ROE outlook is significantly weaker and hence, i argue that perhaps 0.6x-0.7x P/B is fair for de-merged SCI.
Thirdly, on your valuation for SMM, at your TERP of SGD0.264, the implied valuation for SMM is 0.6x-0.7x P/B, which once again is overvalued in my opinion. Given the structural headwinds facing the sector, dwindling order book, weaker B/S, perhaps SMM should trade much lower than 0.5x P/B? Corresponding, i would imagine the rights to be traded at a discount to the listed rights price post ex-rights.
In short, based on my assumptions above, the de-merged SCI should be worth SGD1.17 at 0.65x P/B while SCI’s share of SMM should be worth SGD0.74 at 0.5x P/B, which would imply SCI to be worth SGD1.91. Hence, Fully Valued.
The very fact that SCI is able to benefit from this corporate action is largely premised on 2 fronts – 1) Conversion from a low yielding debt on its loan to SMM into rights to SMM at a huge discount, which are subsequently paid out as dividends in specie; 2) Major dilution in SMM’s minority shareholder. There is NO fundamental improvement in the new company and demerged-SCI shouldn’t re-rate beyond its peers with similar ROE profile and business risks.
Once again, thanks for the article but just offering a different perspective.
Thanks
Puzzled Reader
Thank you so much for the comment and we truly appreciate the time taken to write it all down. You are definitely someone who knows the Sembcorp Industries and Sembcorp Marine incredibly well. We are very flattered that you’ve read our article!
We would just like to offer our opinion on the points you raised.
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***ON DEMERGED SEMBCORP INDUSTRIES***
1) On the Demerged Sembcorp INDUSTRIES (demerged SCI), thank you for your points. According to our calculations, the ROE for demerged SCI is around 12.3% in FY 2020 but this 12.3% is highly funded by debt. Assuming the company delevers over time, we would defer to your 8% normalized ROE. While this is on the lower end of the ROE comp range (5.3% for 9513 JP to mid-teens for others), the peers with high single digit ROEs would be CK Infrastructure (1038 HK. 1x P/B, 10x P/E, 8.4% ROE) AND Power Assets (6 HK, 1.1x P/B, 13.8x P/E, 9.6% ROE). We see the 0.65x P/B you suggested as too steep a discount to 1-1.1x P/B of these peers with similar ROE. As you mentioned, these peers have assets that are primarily in Developed Markets. On your reference to India, we note that India’s revenue contribution for the demerged SCI would be around 24% (2nd largest revenue contribution country after Singapore). While the largest out of all foreign countries, we note that the portfolio as a whole remains fairly diversified. The contribution from Developed Markets would be roughly 65%. For this reason, we still view SCI as a primarily Developed Markets play.
2) I’ll admit. The substantial stake held by Temasek also gives us comfort.
3) On your 0.65x P/B valuation, we looked at the implied Cost of Equity for the stock. Using the Gordon Growth Model, P/B is (ROE-g)/(COE-g). If we use this formula and work backwards, and applying the 8% normalized ROE you provided and a 0% terminal growth rate, to reach a 0.65x P/B value as you mentioned would imply a Cost of Equity (COE) of 12.3%. To us, this appears like a really high Cost of Equity to use for a Temasek-owned utilities company.
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***ON SEMBCORP MARINE***
4) On the value of Sembcorp MARINE (SMM), we will defer to your fair valuation of 0.5x P/B, since you appear to know more than us. However, on our ascribed valuation on the SMM, it’s a reflection on what we estimate SMM shares can be sold at. Here-in, we would like to mention what we believe is the likely trading performance of SMM during these various corporate actions.
4A) SMM between ex-rights and end of rights scrips trading date: As in the case of SIA recently, a lot of investors will likely want to sell the rights, which would put pressure on the right scrips *trading* price, and which would then have a spillover to the “main” SMM share. E.g. if the rights scrips end up trading at 2 cents, investors would then price the “main” share at 22 cents, etc.
4B) Immediately after the new shares listing date: Logically speaking, a bulk of these shareholders would have subscribed to the rights at S$0.20. With reference to your 0.5x P/B, it wouldn’t make sense for these shareholders to value their equity injection at 0.5x immediately post the rights issue, especially since they’ve paid just paid cash (selection bias). Our S$0.264 refers our expected SMM value during this period.
4C) After SCI shareholders receive the SMM shares: We continue to use S$0.264 as a base. I think it’s anyone’s guess as to where it will actually trade, and we made our best estimate of *current market expectations* using our adjusted TERP.
4D) Over time, SMM may drift to 0.5x P/B of S$0.17, as per what you mentioned.
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***ON SEMBCORP INDUSTRIES (CURRENT)***
5) If we ascribe the same S$0.264 per SMM share ex-rights but place a lower “target” 0.945x P/B for the demerged SCI (10% discount to 1.1x Power Assets and 1x CK Infra), we would get a S$2.39 to S$2.57 “target price” for the current SCI (depending on the no. of SMM shares given out), which is still significantly above current levels.
6) Following the above, we were actually thinking of pairing our long position in SCI with a short on SMM (to start on the ex-rights date) to buffer against negative moves in share price for the SMM component. This would allow us to hedge before the SMM shares are received. This seems to be a good idea in light of your comments. We’ll update the article accordingly for our readers, perhaps once the EGM is approved. We originally wanted to avoid writing about the short for fear of further complicating what may appear to be a long and complicated article… But given your very valid points, I think it’ll be worthwhile to include a note on that. Thank you!!