3 compelling reasons for buying into Singapore rig builders

Despite rising competiing and earnings risks.

OSK-DMG has upgraded to Overweight Singapore's rig builders, which have underperformed the STI due to concerns over rising competition and consensus earnings downgrades.

The research firm has turned positive on the sector due to the potential recovery in shipbuilding orders and the fact that tightening credit may ease competition for offshore orders. There is also the risk of EPS downgrades declines. Finally, valuations look appealing leading into the FY14 earnings.

Here's the full analysis from OSK-DMG:

We upgrade to OVERWEIGHT Singapore’s rig builders, which have underperformed the STI due to concerns over rising competition and consensus earnings downgrades. We turn positive as: i) the potential recovery in shipbuilding orders and tightening credit may ease competition for offshore orders, ii) the risk of EPS downgrades declines, and iii) valuations look appealing as we roll forward to FY14 earnings. We prefer SMM over KEP and SCI.

Return of ship orders could ease competition. Data from Clarksons indicate that newbuild prices and new orders are improving. We are of the view that the revival of shipbuilding orders will divert the attention of South Korean and Chinese mega yards toward seeking ship orders rather than offshore orders, thus bringing some relief to the intense competition in the offshore market.

Tighter yard capacity could boost pricing power. Dalian Shipyard has secured orders for nine jackup YTD, of which eight are from Seadrill and one from PT Apexindo. These are due to be delivered between 2Q15 and 3Q16. We believe Dalian has largely filled its near-term slots. As other Chinese yards jostle to win the confidence of blue chip customers and credit conditions imposed on the weaker yards tighten, we believe the pricing power of Singapore shipyards may improve.

Lower risk of EPS estimates downgrades after huge cuts. We previously argued that street EPS expectations for FY13 and FY14 had been too bullish and may lead to downward revisions. Since Nov 2012, consensus has cut EPS estimates for KEP, SMM and SCI by 5%, 23% and 13% respectively. As we believe the earnings downgrades for rig builders are close to the bottom, their downside risks are now lower.

Positive earnings pace heading into FY14. Rig builders saw earnings decline in 1H13 as operating margins normalised. We expect their earnings momentum to swing back to positive growth in FY14.

Prefer SMM over KEP and SCI. We believe SMM (BUY, TP: SGD5.60) is a more leveraged play to the positive outlook. The key risks to our view are: i) expansion in rig building capacity by Chinese state-owned yards, ii) a steep drop in crude oil prices, and iii) execution risks in Brazil.