Friday, August 28, 2009

Swiber – Reasons and Rationale for Divestment

With the announcement on August 27, 2009 of Swiber’s issuance of a convertible bond (CB) of up to about US$78 million, with up-size option to raise a further US$22 million, I realized immediately that the Company’s cash position was in jeopardy and that my investment in the Company was becoming increasingly risky, which translated into an untenable situation of which I had to take action.

The terms of the CB are for a conversion price of S$1.20 per share, with the condition that the conversion price can be adjusted DOWN to S$1.08 if the average price falls below 90% of S$0.96 in the preceding 20 days prior to issue date. The conversion price reset can go as low as S$0.864, which means with each revision downwards in the conversion price, the potential dilution factor becomes ever larger. Total new shares converted without up-size option is 93.6 million, representing 18.5% of existing share capital of 507.76 million shares, and this can potentially increase with either the upside option being exercised or the revision in the conversion price. A dilution factor of 18.5% alone is already massive, but with the possibility of further dilution then I must say this is a bad deal for existing shareholders. Add to that the interest rate of 5% per annum payable semi-annually – this will increase their finance costs and reduce cash flows further for another 5 years. The worst part of the deal is that the funds are to be used for “working capital and general corporate requirements”, thus implying that there is no exact purpose for the fund raising (not for vessel fleet expansion, or for pre-emptive opportunities).

Considering that a share placement of about US$49 million was done (at 88 cents per share) just in June 2009, it is disappointing and highly suspicious as to why Management had decided to raise funds for a second time in less than 3 months. One of the immediate reasons which comes to mind is that the Company has cash flow problems and that their operating cash inflows are not enough to support both fleet expansion, working capital requirements and to pay interest on existing borrowings. This puts the situation in a whole new light and the issuance of this CB is (to me) an obvious sign of cash flow strain for Swiber, even though they had clearly and explicitly communicated just 6 months ago that they had enough cash raised from bank loans, internal funds and sale and leaseback transactions.

Other pertinent reasons relating to the divestment decision are as follows (in no particular order of significance):-

1) Depressed gross margins as reflected in the Income Statement. This had been going on for more than a few quarters and gross margin has been on a steady decline since 2007. The first few reasons given was that their vessel fleet was not ready and so many third-party subcontracting costs were incurred, thus bumping up their COGS and reducing gross margin. Then, the shocking announcement was made for 4Q 2008 financials that they had incurred a gross loss for that quarter, based on the same reasons as given and because their vessels (originally scheduled for delivery), had not been delivered in a timely fashion. Then, for 2Q 2009, they revealed that they had spent US$23.6 million on fabrication costs (relating to sub-contractors) compared to just US$10.6 million (a more than 100% increase) which pushed down gross margin; and this is even though their vessels had already been delivered in 1Q 2009. This persistent unpredictability of gross margin and rampant “shocks” do not reflect well on Swiber’s cost control, and my reason for investing is to ensure a certain level of predictability and stability; and not to see gross margins being subjected to a roller-coaster ride.

2) Increase in financing costs as a result of higher gearing will continue to impact both their profit and loss statement as well as their cash flow statement. In addition to new bank loans secured as well as their medium-tern notes, Swiber has now pulled off a CB and this will add to their debt significantly. Gearing is much too high for me to feel comfortable considering that their order book is not growing at a similarly fast pace.

3) US$71.2 million worth of bonds need to be repaid by 3Q 2010, and from their cash flow statement one can see that most of their cash is being generated from financing activities, and not operating activities (refer to my previous post on Swiber’s 1H 2009 financial analysis and review). This clearly shows that operating cash inflows are insufficient to sustain the business and provide working capital, so Management has had to constantly tap the capital markets for funds. With cash balance just hovering at US$59.4 million (as at June 30, 2009), there is sufficient concern that cash balances may be further strained to pay back the bonds, as well as any maturing bank loan facilities.

4) The dilution factor in the two most recent fund-raising activities cannot be simply ignored. The first fund raiser was back in June 2009 with 84 million new shares being issued at S$0.88 per share, diluting existing shareholders by about 20% of the then-issued capital base of 421,355,000 shares. Now, with the issuance of the CB, another potential minimum dilution factor of 18.5% will be applied to all existing shareholders, further reducing EPS ceteris paribus.

5) Contract flow has lessened considerably with the onset of the global financial crisis, and a weak point about Swiber (compared to Ezra’s business model) is that their contracts are of short duration and are not locked in for long periods (unlike Ezra with 3 to 5 year contracts with oil majors). This means that order book is constantly being depleted and has to be replenished quickly in order to keep the top-line healthy and to ensure cash inflows keep coming in. If one had noticed, tender book for Swiber had increased from US$2 billion to US$5 billion to a recently reported US$7 billion for jobs from 2010 to 2015. One must question how much of this tender book can actually translate into order book, as their “hit rate” has not been historically high. So far they only clinched US$80 million for 1Q 2009 and US$93 million for 2Q 2009, this implies that about US$340 million will be clinched for the FY 2009, by extrapolation. Comparing this to their more robust order book back in 2007 when they secured larger contracts of more than US$100 million per contract, this begs the question – if they have a larger fleet size and are able to bid for higher-value projects, then why are the current jobs secured in 1Q and 2Q 2009 smaller than the ones secured back in 2007 and 2008?

6) Many of the recent corporate actions undertaken by Swiber had also hinted to me of their urgent need for cash, as evidenced by the following:-

a. Swiber and ICON Capital to jointly own Swiber Victorious (announced in March 2009). If they had enough funds they would not sell part of their vessel to ICON and cede part of their ownership in this vessel;
b. Divestment of 30% share of OBT in April 2009 for US$3.9 million, at cost instead of at a premium. This had, to me, hinted that they needed cash or they would have negotiated for better terms relating to the divestment;
c. Sale of shares in Perfect Motive in June 2009 for RM 200,000, when the book value of Perfect Motive was RM 324,000. Another loss had been realized on this divestment. No motive or rationale for divestment was provided for both cases.

7) One aspect of Swiber’s business model which confused me was why they had to have so many alliances with regional partners, since they were prepared to grow their own fleet. Theoretically, with one’s own fleet, one should be able to bid for larger projects and contracts on one’s own merit, instead of having to share resources and rely on a partner’s help for their projects. Yet, it is the very nature of larger EPCIC contracts where more than one party is required; hence the total profits simply cannot accrue to one party. This makes me question the market dominance of Swiber, since there are other offshore players which are offering similar services in the region which act as competitors. Since Swiber had tied up with so many regional players since 2007, theoretically this should garner them more contracts, but it did not appear to be so. In fact, if we contrast Ezra’s business model, they are able to clinch contracts on their own with oil majors and national oil companies without relying on “synergistic” relationships as a catalyst. This in itself is an attestation to their brand name and reputation, of which I feel Swiber is lacking.

8) Swiber has also put several initiatives on hold, while others are mere talk or speculation. The first was the wildly hyped up Equatorial Driller, which was touted as an alternative to traditional drillers; but this plan and the entire project was shelved due to the onset of the global financial crisis, leaving the plan in limbo; and no more was said of this since then. The problem was that Swiber had hired a very experienced team of drillers headed by Mr. Glen Olivera, of which they had to pay monthly salaries, and in the end this team ended up with less work than originally intended, as Swiber only has a small drilling project with NuCoastal in Thailand. At the AGM, they clarified that they were selling services relating to drilling in lieu of the postponement of the Equatorial Driller plans, but does that justify the high cost of maintaining an entire drilling team?

9) The other initiative which was talked about in presentation slides was wind energy and wind farms, and how Swiber could technically deploy their vessels to service this new and growing industry. What made me uncomfortable was that Swiber seemed intent of moving out of their comfort zone without even having established a firm foothold in the EPCIC and drilling arena; and the plans sounded lofty and ambitious but without much substance. Ultimately, if something is being discussed and put into presentation slides, one would assume that Management has been working on something concrete but so far Management has not provided updates nor given a progress report on this planned initiative.

As a result of the above, and due to my nagging discomfort with the way the Company is being managed and issues with cash flow and dilution, I have decided to divest the shares of Swiber and have done so at a price of 95.5 cents, crystallizing a gain of 19% on my initial investment. With a holding period of about 2.5 years, this translates to a return of roughly 7% per annum (it will be lower if you factor in compounding). Please note that even though a gain was recognized on this transaction, it is still (and will be) classified as an “investment mistake”* because of the underlying principles behind the decision, which resulted in the move to divest much earlier than I had intended for. The proceeds will now be shifted to an opportunity fund to await deployment once I have identified another suitable investment opportunity. Proper care and due diligence will be exercised to prevent a mistake of a similar nature.

*Note: Every buy and sell decision which I make must be supported by justifications based on factual data and a complete and objective analysis of the facts at hand. There is no room for “falling in love” with a company and hugging its shares for dear life, even when something fundamental has occurred which frustrates my original intention for investing in the Company. This is in line with my investment philosophy of keeping a close watch on the companies which I own, to assess if they begin to diverge from my fundamental investment objective(s).

Disclaimer: The above are merely personal opinions and observations relating to my decision to divest the shares of Swiber Holdings Limited. It is NOT to be taken as an inducement to buy or sell shares in the Company, and I shall not be held responsible for any losses relating to said decisions. Please consult your lawyer, accountant or other qualified professional before undertaking important financial decisions which could have an adverse impact on your wealth.


Jeremy Ow Tai Pang said...

Hi MW,
Good write-up on your reasons for divesting Swiber. I think your decision to divest Swiber is based on sound facts about the company based on your write-up. I like and agree with your concept of never marrying a stock and one should invest based on facts and not emotions about a company. This is sound investing at it's very core 'based on facts and only facts alone'. If perceived fundamentals have changed, one may have to make an investment calling to divest the shares of a company from one's portfolio or to stick with the company if one has assessed that the company can have a chance to turn around it's negative fundamentals for the better in future.

simon said...

hi mw,

how did you get the figure of 93.6m of new shares?

Musicwhiz said...

HI Jeremy,

Thank you. Looking back, it was quite a pity I had Swiber as my "wild card" investment; mistakenly thinking that sooner or later their op cash inflows would exceed their financing and investing cash flows. Quite a foolish thought since this is a capital intensive business, as even Raymond Goh had mentioned in the press release.

By contrast, Ezra had actually reached a stage of their growth where they can milk their assets and enable them to command higher margins without additional capex. Whether this works out or not remains to be seen, but is far better than Swiber's repeated fund raising which includes medium-term notes and now CB.


Musicwhiz said...

Hi Simon,

Issue size of CB = US$78 million (not accounting for upsize option).

Issue Size of CB = S$112.32 million (using 1.44 USD to SGD).

Conversion Price = S$1.20 per share.

Divide the issue size of CB S$112.32 by $1.20 per share to get 93.6 million shares.


Joseph said...

Your analysis is excellent. But you must be feeling quite lousy to cut at 95.5 within mins of trading when it hit 1.04 within 2hrs of trading on Friday. I'm even worse -sold on Monday at 94.5c - just 1 miserable day before halt. How miserable I feel!

Musicwhiz said...

Hi Joseph,

Thanks for visiting. I must reiterate that the basis for selling is not to catch the "highest price" or even a much better price; but is based upon the reasons as stated in my blog post. I am evem lucky to have made a gain considering my logic in investing in Swiber was not totally sound to begin with.....


Cillin said...

"... the Conversion Price will reset downwards but in any event no less than S$1.08."

Not sure did I misunderstood, I thought the lowest conversion price will be $1.08 no matter how low are the share price.

Musicwhiz said...

Hi Cillin,

According to a summary of the CB provided by CIMB GK Goh (in their Daybreak), apparently the conversion price can adjust downwards further if certain conditions are met.


Chern Kuan GOH said...

Dear mw,

Thank you for writing all these on your blog. I am starting to learn the ropes of investing and have really learnt a lot in depth from your experiences! =)

I really enjoy the way you analyze your experiences. It also fine tunes some of the mistaken concepts in my mind with your real life experiences.

Looking forward to learn more from you in the future.


Musicwhiz said...

Hi CK,

Thanks for the comments, please do visit more often and help me improve the quality of the blog! Hehe.