Tuesday, March 27, 2007
China Oilfield Services (2883): Where's the Service?
This is a nice detour from the tough job of reading the Sinopec financial statements.
COSL announced yet another pleasant results with 37% increase in 2006 earnings. And it doesn't appear the momentum is slowing down. COSL has plans for major capex and will be raising both debt and equity, but more on that later. Since listing at the end of 2002, COSL has had a EPS compound growth of 32%, or a triple over 4 years. Even taking out the effect of the tax break it's gotten since 2003, when its income tax rate was reduced from 33% to 15%, pre-tax earnings showed 29% compound growth. Making this record more impressive is that COSL has had no debt for most of this time until last year, even then debt level was still held at very manageable level (d/e: 23%).
COSL looked to me like a perfect beneficiary of the oil boom. Even real estates of Calgary and Edmonton, two oil cities in Canada, have gone skyrocketing again after many years of drought since the end of last oil boom in the 80s. With the US not having much success on international affairs and its influence fading, COSL with its Chinese background is looking more attractive in the eyes of lesser developed oil countries in the Middle East, Africa, and South America. Don't forget Russia is also China's long time buddy.
Moreover, COSL being a fee-based service company, as opposed to an oil producer, has the added advantage of not having to worry about the rise and fall of oil price too much. Just in case you don't know what COSL does, in simplest terms it does everything an oil company requires to find oil and to produce oil on sea. In more difficult terms it does geophyiscal services, drilling, well management, marine support and transportation.
At first I thought of COSL as a Li & Fung or HAECO type of service organization, those that require great skills but little hard assets to operate on. Afterall aren't we told it's getting harder and harder to find and produce oil? But one look at the historical financials suggests otherwise, rather something to the opposite. ROA for each of the past 5 years were surprisingly low at mid-to-high single digits and ROE weren't much better barely reaching 10%, except for last year when it was 13% with some debt in place. So it's a pretty darn capital intensive business. The question next came to my mind was why I'd want to pay over 3x p/b for assets that yield so little. What am I buying into if it's not great service?
Could this national franchise* to drill, as long as it's above water, be worth so much? I'll simply call COSL the driller from here. I think it's a carved out bit from the E&P unit of CNOOC (this explains the heavy capital requirement), who has been its biggest customer for over 60% of its business every year since listing. Clearly the driller can't survive on its own. But equally there's no ground to suggest CNOOC will ditch the driller, for it's detrimental to both its daily operation and 62% equity investment.
How's the fee to be determined between CNOOC and the driller? The official line is to charge no less than the current market rate. But whether that's entirely accurate is another issue when the two are intermingled and CNOOC takes up so much volume of the business. And I doubt cost difference, if any, will be apparent enough to an outsider given the the complexity and technicalities of the matter. However having observed how listed state-owned companies operate for some time, I'd say they are actually quite fair in their dealings. So I guess the fee would approximate a reasonable return on the assets employed, making the business model look like an utility, in particular that of a power company. Another similarity is that once a rig (drill tower) is in place and production starts, it'll probably stay there until the well has been depleted, which will be many years down the road.
Following this logic cost containment should be the focus since revenue is relatively stable. I want to find out if the driller, like other oil companies' E&P units, also faces the problem of increasing costs. But if it's on the receiving end, i.e. it can pass on the costs to CNOOC, then the current situation is actually conducive to its businesses.
Both the daily rate (price) and the utilization rate of the rigs have increased over the past 5 years. The pre-tax profit margins, however, were more or less 20% during these years (save for last year's higher margin of 22.8% due to the use of leverage), so operating costs had increased but it appeared to have been passed on to customers. Expansion provided further earnings growth as 3 rigs were added to the lineup which is now 15.
Unlike the power companies, the driller hasn't make good use of its balance sheet by borrowing as much as it can. Management has stated it's gonna increase its gearing from 23% to somewhere between 50-100%. This will probably lead to another 10-20% growth in earnings assuming the new assets won't yield less than the present ones.
Up to now the driller's p/e of 21x appears justifiable or even to the low side for a high growth utility.
This final bit is the spoiler. Don't read further if you are keen to buy now. Like Sinopec, capex has been multiples of depreciation for each of every year since listing. Rough calculation showed the remaining life of all productive fixed assets at the end of 2005 was only 7.3 years! This was already improvement from 6.8 years at the end of 2002 but still short by any measure. If you look at the lineup of the self-owned rigs you'd be impressed that only one belongs to the 90s and the second youngest has already 24 years in its service. So over the next few years the driller will have to replace its fleet, and at higher current costs too (read: higher depreciation and lower dividends). I tried but couldn't quantify the earnings effect. But if the driller could pass this cost too to CNOOC and other customers, then my worry is overdone. Now I'm undecided.
Don't let that name fool you, this aint' a service business but rather an utility with old equipment.
DISCLOSURE: I don't hold 2883 at time of writing.
* it's been the government's policy that CNOOC be responsible for all China offshore and overseas oil exploration and production activities, whilst Sinopec and PetroChina be restricted to that on land only. but this distinction could get blurry when everyone is fighting for oil now.
COSL announced yet another pleasant results with 37% increase in 2006 earnings. And it doesn't appear the momentum is slowing down. COSL has plans for major capex and will be raising both debt and equity, but more on that later. Since listing at the end of 2002, COSL has had a EPS compound growth of 32%, or a triple over 4 years. Even taking out the effect of the tax break it's gotten since 2003, when its income tax rate was reduced from 33% to 15%, pre-tax earnings showed 29% compound growth. Making this record more impressive is that COSL has had no debt for most of this time until last year, even then debt level was still held at very manageable level (d/e: 23%).
COSL looked to me like a perfect beneficiary of the oil boom. Even real estates of Calgary and Edmonton, two oil cities in Canada, have gone skyrocketing again after many years of drought since the end of last oil boom in the 80s. With the US not having much success on international affairs and its influence fading, COSL with its Chinese background is looking more attractive in the eyes of lesser developed oil countries in the Middle East, Africa, and South America. Don't forget Russia is also China's long time buddy.
Moreover, COSL being a fee-based service company, as opposed to an oil producer, has the added advantage of not having to worry about the rise and fall of oil price too much. Just in case you don't know what COSL does, in simplest terms it does everything an oil company requires to find oil and to produce oil on sea. In more difficult terms it does geophyiscal services, drilling, well management, marine support and transportation.
At first I thought of COSL as a Li & Fung or HAECO type of service organization, those that require great skills but little hard assets to operate on. Afterall aren't we told it's getting harder and harder to find and produce oil? But one look at the historical financials suggests otherwise, rather something to the opposite. ROA for each of the past 5 years were surprisingly low at mid-to-high single digits and ROE weren't much better barely reaching 10%, except for last year when it was 13% with some debt in place. So it's a pretty darn capital intensive business. The question next came to my mind was why I'd want to pay over 3x p/b for assets that yield so little. What am I buying into if it's not great service?
Could this national franchise* to drill, as long as it's above water, be worth so much? I'll simply call COSL the driller from here. I think it's a carved out bit from the E&P unit of CNOOC (this explains the heavy capital requirement), who has been its biggest customer for over 60% of its business every year since listing. Clearly the driller can't survive on its own. But equally there's no ground to suggest CNOOC will ditch the driller, for it's detrimental to both its daily operation and 62% equity investment.
How's the fee to be determined between CNOOC and the driller? The official line is to charge no less than the current market rate. But whether that's entirely accurate is another issue when the two are intermingled and CNOOC takes up so much volume of the business. And I doubt cost difference, if any, will be apparent enough to an outsider given the the complexity and technicalities of the matter. However having observed how listed state-owned companies operate for some time, I'd say they are actually quite fair in their dealings. So I guess the fee would approximate a reasonable return on the assets employed, making the business model look like an utility, in particular that of a power company. Another similarity is that once a rig (drill tower) is in place and production starts, it'll probably stay there until the well has been depleted, which will be many years down the road.
Following this logic cost containment should be the focus since revenue is relatively stable. I want to find out if the driller, like other oil companies' E&P units, also faces the problem of increasing costs. But if it's on the receiving end, i.e. it can pass on the costs to CNOOC, then the current situation is actually conducive to its businesses.
Both the daily rate (price) and the utilization rate of the rigs have increased over the past 5 years. The pre-tax profit margins, however, were more or less 20% during these years (save for last year's higher margin of 22.8% due to the use of leverage), so operating costs had increased but it appeared to have been passed on to customers. Expansion provided further earnings growth as 3 rigs were added to the lineup which is now 15.
Unlike the power companies, the driller hasn't make good use of its balance sheet by borrowing as much as it can. Management has stated it's gonna increase its gearing from 23% to somewhere between 50-100%. This will probably lead to another 10-20% growth in earnings assuming the new assets won't yield less than the present ones.
Up to now the driller's p/e of 21x appears justifiable or even to the low side for a high growth utility.
This final bit is the spoiler. Don't read further if you are keen to buy now. Like Sinopec, capex has been multiples of depreciation for each of every year since listing. Rough calculation showed the remaining life of all productive fixed assets at the end of 2005 was only 7.3 years! This was already improvement from 6.8 years at the end of 2002 but still short by any measure. If you look at the lineup of the self-owned rigs you'd be impressed that only one belongs to the 90s and the second youngest has already 24 years in its service. So over the next few years the driller will have to replace its fleet, and at higher current costs too (read: higher depreciation and lower dividends). I tried but couldn't quantify the earnings effect. But if the driller could pass this cost too to CNOOC and other customers, then my worry is overdone. Now I'm undecided.
Don't let that name fool you, this aint' a service business but rather an utility with old equipment.
DISCLOSURE: I don't hold 2883 at time of writing.
* it's been the government's policy that CNOOC be responsible for all China offshore and overseas oil exploration and production activities, whilst Sinopec and PetroChina be restricted to that on land only. but this distinction could get blurry when everyone is fighting for oil now.
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