Ezra – FY2009 Financial Analysis and Review Part 2

This is part 2 of my analysis and will focus on dicussions on EOC, shipyard, fleet management contracts and other salient aspects. Note that there are many facets to a company and I choose to cover those which I feel are more impactful in terms of the long-term prospects of the Company, and I may leave out minor aspects this time around if they do have any significance in this discussion.

EOC and Shipyard Updates

It was recently announced on October 12, 2009 that EOC’s Lewek Champion was awarded a contract worth US$11.2 million by NuCoastal, and this was confirmed to be a bridging contract as the vessel is now between projects, and is under negotiation for more long-term charters to ensure cash flow stability. The other two vessels Lewek Conqueror and Lewek Chancellor are both chartered out to Brunei, though the charter for Chancellor is ending in Nov 2009 and it under negotiation now. Lewek Conqueror has the longest firm charter extending till March 2014, but for the other two vessels (excluding the FPSO Lewek Arunothai), the contracts are shorter and have to be renewed.

Another issue is that 48.5%-owned EOC has very high debt-equity ratio of 2.31x (up from 2.12x as at August 31, 2008) and it was NOT mentioned on how EOC planned to reduce this gearing. If this gearing was added to Ezra’s gearing, it would present a significantly different picture as the overall gearing of the Group would be substantially higher. Recall that Ezra managed to hive off EOC in a separate listing on Oslo Bors in 2008, freeing up cash in the process and also removing a large chunk of their (then) debt. But the debt cannot be wished away, and it now resides on EOC’s Balance Sheet instead. This could be a major risk moving forward as EOC owes a sum of US$32.8 million to Ezra and as yet will be unable to pay up unless they find a way to reduce their gearing. The good news is that EOC have positive operating cash inflows but also has high capex requirements (op cash inflow +US$37.8 million for FY 2009 but invest cash outflow US$107 million). Thus, most of the cash still has to come from financing activities (+US$68.7 million for FY 2009) to finance this growth.

As for Saigon Shipyard, according to Management it is now operating at full capacity and they see the potential for more fabrication and construction contracts in the near future. Note too that the yard will be used to construct the new ice-class vessel Ice Maiden and this will require more cash outlay. At this point in time, not much else is known about how much time, effort, resources and cash is needed for this project. Management also mentioned scaling down the development of their second yard at Vung Tau for now and it remains a Greenfield project.

Fleet Management Contracts

Ezra recently announced a fleet management contract whereby they get to provide expertise to manage 4 AHTS owned by a specialized fund, in return for a 50% share of the profits. From my conversations with Management at the EGM, it seems that this Fund had been one of many which tried to “flip” vessels during the boom years in 2007, buying and selling quickly to make instant gains. Unfortunately, it got caught by the financial crisis and could not sell off its vessels at a profit (their value had since gone down) and these vessels are now being constructed and will be chartered out to clients once completed. Since the specialist fund has no idea how to operate these vessels (as they were just an opportunistic bunch) and has no manpower available, they engaged Ezra who will provide the manpower and the expertise. Thus, this represents a fixed cost to Ezra (to deploy any excess capacity to man these 4 vessels) and can be viewed as pure profit as no capex is required. However, I also get the impression that such deals are ad-hoc in nature as it’s not every day that you see Funds sitting high and dry with assets lying idle. Hence, this may be one of the methods Ezra uses to grow without capex but I do not think it can be done so consistently enough.

Purchase of ROV (Remotely Operated Vehicles)

Ezra also recently announced the purchase of 5 ROVs for US$23 million from Triton, in order to install them onto their own vessels to enhance operational capabilities. Further clarification at the EGM told me that these ROVs would actually be installed onto the vessels itself (instead of being used independently) to conduct deep-sea operations and this can significantly enhance the operating flexibility of each vessel, which is in line with Ezra’s commitment to providing more value-added services to customers.

FPSO Matters

It has been reported that EOC is the front-runner for the Chim Sao FPSO Project in Vietnam, but that due to financing issues, EOC could not successfully bid for the project. This is quite a pity because it EOC can secure this second FPSO it would really be able to showcase their talents and put them on the global stage against major FPSO competitors. As such, its gearing level is simply too high to take on more debt at this point, and I feel a share placement or some other form of innovative financing may be required for it to secure the Chim Sao Project.

Meanwhile, Lewek Arunothai has also encountered teething problems in drawing first gas and the delay has been extending since 2Q 2009. Management has said that the gas is not yet commercially recognized by the client and they hope revenues will be able to flow in to EOC from 1Q 2010 onwards. Otherwise, since the announcement of the FPSO contract in 2006, it has been about 3 long years with still no revenue contribution from this FPSO.

Deepwater Subsea Division

Management has come up with a comprehensive set of presentation slides for the formation of their new deepwater subsea division and they have plans to package complete solutions for clients so that they can become a “one-stop solution” for customers. This will make Ezra a more attractive service provider and also mitigate risks for customers as they will have to deal with just 1 party instead of more than 1, and with vessels ready to be deployed at many stages in the O&G cycle. I hope that this division can improve its gross margins from the current 13% and also garner higher value contracts since Ezra will be offering packaged solutions. It remains to be seen if more significant capex is needed but from the way Ezra’s business model has worked in the past, I suspect this trend will continue at least until 2015 (which is the time they projected till).

The “Ice Maiden” – An Ice-Class Vessel

If one looks closely at the share placement fund proceeds utilization, Ezra had spent about US$6.15 million purchasing the shipset of a vessel called “Ice Maiden” from Silters & Co. This is an ice-class vessel which is capable of working in harsh Arctic waters and was part of a high-profile Shell contract back in 2007 before it was abandoned in 2008 due to cost overruns. Ezra has mentioned that they bought the vessel at “distressed” prices and that such vessels, being rare, can command premium charter rates. Ezra’s shipyard will build the vessel and it is expected to be completed around FY 2011/2012; so not much will be known about this until then, and whether or not it can be chartered out (and at what rates). In terms of expanding their deepwater subsea offerings, this represents a maiden (but tentative) step in the right direction but I would caution that it is premature to be too optimistic at this point as there are still many unknowns and uncertainties surrounding this latest acquisition, even though the press release is worded with a very positive slant.

Partial Divestment of Ezra – Rationale and Reasons

As a departure from my usual investment philosophy of buying and holding, I had decided to divest a portion of my holdings in Ezra at a price of S$2.01 last Friday October 16, 2009. This divestment has wholly covered my entire cost of investing in Ezra and my remaining stake in Ezra represents pure profit. I will account for the partial divestment by using weighted average costing (i.e. S$0.629 as my purchase price), thus recognizing a gain of about 220% on my investment. This is due to the “Matching” concept used in accounting whereby the revenues generated from partial divestment must be matched to the exact costs relating to the revenues; so even though the total proceeds represent a return of my full cost I still have to account for it as such. The reasons for the divestment have been stated all over my analysis, but I will summarize them here (and add a few more) for simplicity and convenience:-

1) Valuations are high at about 13x and a lot of positives, optimism and expectations have been factored in. In short, Ezra is probably trading at a premium to intrinsic value based on valuations alone, and other factors I had mentioned in my analysis has also heightened the risk in the Company;

2) Weak and leveraged Balance Sheet as shown by gearing rising and debt levels increasing,

3) Cash Flow Statement shows negative operating cash flows and most of Ezra’s cash is coming in through financing (i.e. bank loans, bills and share issuance),

4) A certain amount of uncertainty and risk lies ahead in its venture to expand their deepwater sub-sea segment, and I have no doubt it will be capital-intensive, which implies more fund-raising in the future either through dilutive share placements or perhaps even issuance of convertible bonds.

5) Ezra’s business model entails growth through expansion of their asset base, and these assets are costly and specialized. Thus, they always have to incur capex on expensive assets in order to deploy them for cash flows. I have asked and confirmed that the payback period for a vessel is about 4 years; but that is assuming charter rates stay at current levels and that the vessel can be utilized all the while (i.e. no down time or idle time).

6) Risks would include delays in delivering vessels on time, thus incurring penalty charges from the client which could wipe out a significant portion of their profits (due to high fixed costs and depreciation per day); as well as the risks of managing a more complex corporate structure as a result of rapid expansion.

Evolution of my Value Investment Philosophy

Admittedly, the partial profit-taking on Ezra represents a fundamental shift in my investment philosophy, and is a result of modifications and evolution from reading up and thinking on various issues. I was reading up a lot on when a company was considered over-valued, how to hedge my risks, when to sell as well as portfolio management techniques. I have realized that portfolio management is a necessary part of being an investor, and even value investors need to know when to divest (whether partially or completely). Warren Buffett continually divests if he sees better opportunities, if a company has exceeded his computation of intrinsic value or if the original intention to invest has changed.

Selling off an investment which is trading at 13x and perhaps deploying the proceeds to another company which is trading at 4-5x is a more efficient way of allocating capital, as Mr. Market may have realized the value of certain companies much faster than I had anticipated. Note that I have not totally exited this investment as I believe there is still potential for growth in Ezra; but for now my risks have been mitigated and the rest of my stake represents pure profits. Based on my holding period of 4 years and a gain of 220%, this translates into an average annual gain of 55% (not accounting for compounding effects). The gains will be reflected as an addition to “realized gains” in my next portfolio update on October 31, 2009, and my portfolio cost will also be adjusted accordingly.