Ezra - FY 2008 Review and Analysis

Ezra released their FY 2008 results yesterday, and I also took the opportunity to purchase more shares at 59.5 cents to add to my existing holdings. I will be doing a brief review here (not too detailed la) based on their financials, press release and powerpoint presentation. I will also be tackling some very pertinent questions raised by a forumer named "amigos" in the Channel News Asia forums. He obviously delved quite a bit into the industry and asked some good questions about the Group which I would like to address. Hence, I will be copying/pasting his questions on my post and providing the replies to address the relevant issues here.

Profit and Loss Analysis

The good news is that top line has grown 87% from FY 2007 to FY 2008, but this was largely expected with the delivery of more vessels thus contributing to higher recurring revenues for the Group. Also note that the Energy Services division made its maiden revenue contribution of US$29.2 million, though net margins for this division were low at 12% (resulting in a contribution of "just" US$3.5 million for FY 2008. Sales for the Marine Division nearly doubled to US$64.2 million while the offshore chartering division contributed about US$174.9 million to revenues.

Note that gross margins have fallen as a whole for Ezra from FY 2007 to FY 2008, from close to 35% in FY 2007 to just 29.6% in FY 2008. From Page 7 of their results presentation, it can be seen that gross margins for offshore and marine divisions had dipped slightly; probably due to the delays in the delivery of vessels during FY 2008 which meant that Ezra had to charter third-party vessels to complete certain projects. Their Vietnam Yard also could have started off later thus contributing to higher costs (recall that Vietnam's economy is also in the doldrums). I will clarify these issues at the upcoming AGM. As a result of the new division coming on-stream, this had the effect of lowering the Group's total gross margin. Moving forward, the recent news of Ezra winning US$104 million worth of charters for 4 vessels at rates 10-15% higher than previously attests to the continued demand for their vessels; hence gross margins should stay fairly stable around this level.

Let's take the pure recurring net earnings as a basis for comparison, as the FY 2007 and FY 2008 numbers contain a lot of one-off exceptional gains and items like write-offs, provision for forseeable losses, doubtful debts and exchange losses. I draw readers' attention to Page 5 of the presentatio slides which shows recurring PATMI of US$49.9 million for FY 2008, an increase of about 55% over the PATMI of US$32.1 million for FY 2007. Using this figure, net margins for FY 2008 stood at 18.6% while net margins for FY 2007 were 22.4%.

Balance Sheet Review

For the Balance Sheet, I must say it's more well "fortified" now against possible problems as compared to a year ago. Much of this was achieved from the de-consolidation of EOC from Ezra Group's books, thus freeing up a lot of gearing and taking it off Balance Sheet. Note that EOC, being a 48.9% associate of Ezra Group, has gearing of 2.63x which is extremely high. In a way, the Group has sold shares in EOC to dilute its interests so that the debt can be carried by its associate rather than consolidating the debt into the Group accounts. This reduces the risk in its Balance Sheet and at the same time, frees up cash for the Group to continue their expansion plans.

I would like to draw attention to a few items within the Balance Sheet which have improved over the year, and which have also been highlighted by the Management. Cash and cash equivalents has increased 5-fold from US$24.8 million a year ago to the current cash hoard of US$153 million (inclusive of fixed deposits). This has brought down their net gearing from 37.4% to just 11.5%. Also, Ezra's interest cover has improved from 14.8 times to 29 times, in anticipation of more borrowings to fund their next wave of expansion for the MFSV. The Management is preparing for the higher amount of gearing and anticipates gearing will be slightly less than 1x by the end of FY 2011. Of course, their operating cash flows from recurrent charter contracts should be able to fund part of this capex requirement. Interest cover should remain decent even as the Group gears up, as Ezra has done the wise move of NOT paying dividends in order to conserve more cash.

I noted that Citigroup's report mentions the invoking of a "market disruption clause" which seems to be quite in vogue these days due to the credit crunch; but this is unlikely to affect Ezra very much due to my perception that the inter-bank lending freeze will be short-term in nature and interest spreads (LIBOR) should ease in a few months time.

Current ratio at 1.5x is also healthy as compared to 1.4x for FY 2007.

Cash Flow Statement Analysis

The Group is generating positive operating cash inflows of US$17.4 million compared to about US$22 million a year ago. This reflects the effects of their charter contracts which have managed to provide the Group with steady mid-term cash flows. Most of the rest of the cash came from the sale of EOC, more bank loans raised and proceeds from bills payable. There was negative FCF as Ezra is still in the midst of expanding its fixed asset base; hence investors should continue to see large cash outflows relating to the purchase of fixed assets. Their long-term charters should provide cash flow visibility in the near term, while their building up of cash and absence of dividends is a good signal that Management knows how to manage their cash effectively. Please also see the capex and prospects sections which discuss on cash flow requirements for the Group in the years to come.

Capex and Prospects

Ezra intends to expand its fleet into the deepwater segment in order to cater to oil majors committing more E&P dollars to this growing segment. They aim to be one of Asia's first companies to serve this segment, which is lacking in support vessels and which promises to show healthy growth in the coming years. Note that lower oil prices do not affect the committed capex of huge oil majors such as Shell and Chevron as they have already planned to drill in deeper fields for the last 10-15 years. It is my personal opinion that oil prices will not stay depressed for very long (in other words, it's only temporary) and with the recovery of the world economy perhaps by FY 2010, oil prices should start to trend upward again. The world has finite oil reserves and these are being depleted at an alarming rate. Most of the shallow oil fields are depleted and deeper wells need to be drilled to find oil reserves. This will spur the growth of the oil and gas industry into the future (past FY 2012) unless the industry gets threatened by a credible and cheaper substitute.

Ezra's commited capex for their 5 MFSV and one deepwater AHTS amount to US$650 million, while they plan to spend another US$100 to develop their Vietnam yard(s) at Ho Chi Minh and Vung Tau, Academy and Energy Services division. The Group has secured a S$500 million (about US$333.33 million) loan to finance part of this capex, and the remainder should be funded through internal cash flows. The slides mention that funding has been secured, but more needs to be asked on the nature of this funding and the interest rates on the debt. I will be asking this at the AGM as well.

Note that Ezra's policy has been to construct a vessel only when firm demand has been established for it. This means that a customer would have indicated interest in advance to charter a vessel before Ezra undertakes to construct one. This minimizes the possibility that the asset will be left idle when completed; in fact Ezra's new vessels have all been chartered out upon delivery, and existing ones have also been signed on to new charters (refer to press release dated October 20, 2008). Thus, the committed capex should ensure the Group gets firm charters to justify investing this amount of monies into each vessel.

For Energy Services division, Ezra is currently managing a drilling programme with a client called STP Energy in New Zealand. According to the press release, this is on a cost-plus-basis which means rising costs do NOT affect Ezra's profit margin on this contract. It is unclear what "additional upside" means but I assume it refers to revenues of US$25 million. Using a net margin of about 12%, this translates into potential additional net profits of US$3 million. More details need to be disclosed with regards to the nature of this program, the client and the prospects of the division, and I will clarify this during the AGM too.

For EOC, although gearing is very high at 2.63x, the Company has just recently chartered out its FPSO and heavy lift accommodation barge; hence I expect the recurring cash flows to be able to reduce some of this debt over time. In addition, EOC are said to be the front-runner for an FPSO project in Vietnam; I will check with Management on this again by December 2008.

Replies to Queries raised

A forumer raised some interesting queries on Ezra amid the current global financial gloom (yeah, no better phrase for it, since everybody looks set to jump off cliffs going by the current sentiment). I will present each question/issue and my answer to it in turn. Some of the queries may already have been tackled in the earlier section of this post.

Question: With almost certain economic slowdown for next year, global oil demand will inevitably be lowered to region of $50-60. Based on Ezra's expansion projected forecasts, most of their vessels are expensively built for deep water operations. Now, deep water operations are highly expensive stuff and is only feasible when oil price is high. Facing such a scenerio, where does demand for Ezra's vessels stand? Remember, oil companies will not pay big money for expensive vessels to support shallow water operations (that will still be profitable at $50/barrel)

My Reply: Oil prices are not expected to stay around this level for very long, I estimate probably another 2-3 years, once the recession is over (and yes, it will be over, it just depends on the time taken); oil prices should resume their steady climb upwards. Oil majors have committed capex for drilling and E&P in deeper waters a long time back (even before I invested in Ezra probably); so they will not just "pull the plug" halfway because as oil majors, they need to look for more reserves and the shallow water ones are running out. As such, Ezra only builds a vessel when there is firm demand from a customer (as mentioned above). Their smaller vessels should provide stable charters (recurring cash flows) while the future larger ones can command premium rates as they are newbuilds amid a lack of supply.

Question: Expensive vessels - their capex and debt worry is no joke. Think about it, US$650m for 5 MSFV. Vessels like these have never been that expensive in history and Ezra has built 5 of them. How they're going to pay for them (including finance interest) is a big question mark to me.

My Reply: I would like to emphasize that "vessels like these" are non-existent in history as oil majors have never drilled so deep before, so I am not sure what basis of comparison is being used here. Please note that these are highly-specialized and state-of-the-art vessels with many safety and environmental friendly features incorporated in them. The cost is very high precisely because they are unique and suited to specific environments (harsh deepwater); therefore oil majors should be willing to pay premium charter rates for them because without these vessels, they can't do their E&P effectively. Financing should not be a big issue as the Group has essentially secured funding for the vessels and their interest cover of 29x currently should ensure enough buffer for future finance costs. Don't forget that operating cash flows are coming in all the time and will contribute to the cash flow situation positively over time.

Question: Based on their 4Q earnings of a dismal $6m+, how are they going to run their business with such debt obligation behind them? All the industry players are expecting a major slow-down in the oil and gas sector next year. Will their 1Q09 earnings be worse? I'm not ruling that out.

My Reply: I assume you refer to the earnings after the exceptional items have been factored in ? I suggest to cnocentrate less on earnings per se and more on cash flows, which will be crucial in the coming years as Ezra scales up its fleet. Yes, there will be slowdown in the sector because of the global recession, but this is NOT a permanent and irreversible situation and the oil majors and oil and gas support players should be able to weather this. Even if Ezra's 1Q 2009 earnings dip, I do not see a problem with their long-term earnings and cash flows as I am invested in the company to grow with it till at least FY 2012 when their fleet composition stabilizes. By then, they may be quite a different animal. Don't forget about their fabrication yard, energy services division and their potential FPSO win, all may turn out to be positive catalysts.

Question: Contracts, contracts, contracts - Contracts can be signed, they can be void too. When companies go bust, they don't care if contracts are void or if they're sued. Fact is if a business venture doesn't make money, there's no point continuing in a contract that will only see red. Will Ezra's long term contracts be cancelled due to unforeseen circumstances? I'm not ruling that out.

My Reply: Ezra's clients are large oil majors who have been around for a very long time and are established players in the O&G arena. It is very unlikely that they will "go bust" or the world will have to survive on water as fuel instead of petroleum ! On whether the long-term contracts will be cancelled, oil majors cost of extracting oil is VERY LOW, probably only a few USD per barrel; hence there is totally no incentive for them to discontinue E&P activity just because oil prices dropped below US$70 recently. Support services are an essential part of the oil and gas value chain and oil majors cannot do without them. Try installing a topside platform on your own without the proper equipment, or do winching or well-servicing, and you will know what I mean. It's a symbiotic relationship between oil major and vessel charterers. Each will not want to "sabotage" the other and ruin this relationship by cancelling contracts prematurely. Ezra also has the reputation of being a premier vessel provider in South-East Asia, and is one of the few Asian companies owning such assets in the region.

Question: STP who? Does anyone of you know who owns STP energy - the paymaster for Ezra's 2 drilling rigs on time charter to them (Ezra)? If the insiders in the industry don't know who they are, who knows? Everyone in the industry knows that exploration/drilling stage in oil and gas can make or break a company. Either you find oil and you strike it rich, or you go bust with no oil found. In today's climate, either way STP will be in for a rough ride. At time charter rate of $160k a day per rig, even if they find oil, at today's oil price you can be sure the margins will be low. If they don't find anything, the company can just close shop and pat their backsides and leave. The way Ezra is doing business is really worrying. Their reluctance to reveal more about this project and who the hell STP are is really worrying (to the investors that is).

My Reply: I am not sure where Citigroup got their information on STP Energy and why they chose to use this information to show that Ezra was "less than transparent". From my queries with Management through Ezra's IR, the Company has said that the Citigroup analyst had NOT spoken or met up with Management to discuss STP Energy; in other words the analyst did not clarify his concerns and doubts with Management before writing the report. Apparently, parts of the information were pieced together through fragments of news bits found on the Internet; thus I would NOT rely on the rigour of the analyst's reporting due to this. From what I understand, operating an oil rig costs a lot and the figure mentioned is not surprising. Ezra has reiterated tha the contract is on a "Cost-Plus Basis" which mitigates the downside risk of earnings not materializing. As to whether the client is credit-worthy, I shall have to find out more from the Management at the AGM.

I think I have address most of the concerns brought up by this forumer except for the STP Energy one. I think the questions are rather pertinent and am quite glad to be able to answer them. If anyone else has issues to bring up about the industry or company, please feel free to leave a comment.