In our report on Chuan Hup, we suggested that Falcon Energy Group Ltd’s (“FEG”) successful takeover offer for CH Offshore Ltd ("CHO"), which resulted in CHO becoming its 86.7% owned subsidiary, could be a win-win-win situation for all three companies involved. In this report, we take a closer look at FEG and assess its options with respect to its newly acquired CHO stake.

Introduction to FEG

History

FEG has come a long way ever since it morphed from the then Sembawang Music Holdings Ltd ("SMH"), a small music retail business listed on SGX SESDAQ (n.k.a Catalist), via a 2-stage reverse takeover process into an established Oil and Gas ("O&G") services provider.

The transformation began in May 2006, when Tan Pong Tyea, the current majority shareholder of FEG and a long-time veteran of the oil and gas industry, acquired a 55.0% stake in SMH, triggering a mandatory takeover offer and gaining control of the listed entity. SMH subsequently became known as Falcon Energy Group Ltd. With Tan at the helm, FEG began its initial foray into the new core business of Marine and Oil and Gas services.

The new business gained steam when Tan injected his privately held Oilfield Services Company Limited, a well-established company started in 1983, into FEG. The consideration of S$229 million was paid entirely in newly issued FEG shares, further tightening Tan's grip on FEG. The legacy music business was also disposed of along the way to SMH's former controlling shareholder.  

This series of moves laid the foundation for what FEG is today. 

Core Businesses

FEG currently has 5 main business divisions catering to customers in different stages of the exploration and production phase in the upstream O&G sector. The services offered under each division can either be offered individually or integrated and customised to cater to each customer’s specific requirements. The 5 divisions are listed below:

• Marine Division: Owns and operates a fleet of 22 offshore support vessels ("OSVs") that mainly service customers in the production phase of O&G projects. These include one of the largest fleet of Accommodation Work Barges (13) in the region alongside 3 Multi-functional Support Vessels, 1 Anchor Handling Tug and 5 other OSVs.  The Marine division provides a wide range of platform supply and engineering services. 
• Oilfield Services Division: Provides services such as agencies, logistics, procurement and other general support activities to customers like O&G majors, national oil companies (NOCs), contractors and shipyards globally. This division also provides engineering and consultancy services for the construction of oil rigs and OSVs.  
• Oilfield Projects Division: Provides O&G project related services of varying nature such as building and leasing of specialised seismic vessels and marketing agency for oil companies, ranging from small facilities to multi-million dollar heavy oil facilities. 
• Drilling Services Division: Relatively new division started in 2011 to provide drilling and related services to the O&G majors, NOCs and O&G contractors. Through this division, the group has been building up a modern fleet of high specification jack-up rigs via joint ventures (“JVs”) with its strategic partners. The JVs currently have a total of 5 rigs on order: 4 GustoMSC CJ50 and a Keppel FELS Super B Class jack-up. All 5 rigs were ordered in 2013 and are expected to be delivered between mid-2015 to mid-2016. FEG has an effective ownership stake of 25% in these rigs. The Group previously also held stakes in 2 more GustoMSC CJ46 rigs ordered in 2011 but both were sold to China Oilfield Services Limited before they were delivered, netting FEG substantial gains for FY2014. 
• Resources Division: Set up in 2010 to create another energy-related stream of revenue for the group. FEG has acquired the commercial rights to three coal-mining concessions in East Kalimantan, Indonesia. According to FEG's annual report, production of coal was expected to commence in 2014 although we have not seen evidence of this happening as yet: in its latest Profit & Loss statement for the 9 months ending 31 December 2014, 100% of FEG's revenue came from Marine, Oilfield Services and Oilfield Projects divisions. FEG remains on the lookout for further coal acquisitions.   

Figure 1: FEG's services cover the full spectrum of exploration and production phase in the upstream O&G sector. Source: FEG

Recent Financial performance

FEG has in recent years managed to successfully execute its multi-prong expansion plans with both top and bottom line growing more than 4 times since the downturn in FY2010 to US$350.8 million and US$60.8 million respectively in FY2014. We note though, that revenue and earnings for FY2014 were boosted by the disposal of the two GustoMSC CJ46 rigs, without which they would still have been approximately US$222.4 million and US$30.5 million respectively. Although FEG does not appear to have a consistent dividend policy, they have paid dividends of between 0.5 to 1.5 Singapore cents in 4 out of the last 5 years. 

^FEG changed its financial year from December to March resulting in a 15-month financial period straddling FY2012 and FY2013. Profit After Tax and MI adjusted for FEG’s share of a one-off writedown on CHO’s receivables of US$43.95 million during FP2013 of which the outcome is still pending.


Figure 2: FEG's performance in recent years has been on the uptrend. Source: FEG

At the current share price of S$0.27 and implied market capitalisation of S$218.6 million, FEG is trading at a valuation of 5.2 times FY2014 earnings adjusted for gains from disposal of the two rigs, with an above average dividend yield of about 5.6%.  As with all other oil and gas services companies, we expect operational environment going forward to remain challenging although the effect of lower oil prices have yet to manifest itself in the latest reported financial period of 9M2015 ending 31 December 2014 with profit after tax and minority interests already at US$34.2 million. 

CHO shareholders' deadlock finally broken- expect more synergies

FEG had not been able to exert any meaningful control over CHO ever since it acquired its initial 29.1% stake from Scomi Marine Berhad (n.k.a Scomi Energy Berhad) back in 2010, as witnessed by it not having any representatives in a key executive role on board of CHO- FEG Chairman Tan and CFO Gan Wah Kwang are both non-executive board members. This was largely due to Chuan Hup and its associates controlling a higher 35.1% stake in CHO. Now that Chuan Hup is no longer in the picture, we should start to see more integration between CHO and FEG's operations.

We expect CHO's fleet of 15 AHTS, including seven of the 12,240 bhp variety built in Japan, to complement FEG's fleet of mainly Accommodation Work Barges nicely by significantly expanding the scope of services its marine division provides and increasing its fleet capabilities. For more on the 2 types of OSVs, see Figure 3 below. There should also be increased service cross-selling opportunities going forward with the enlarged clientele base as well as geographical coverage. 

Figure 3: FEG's AWBs vs CHO's AHTS. Source: Intership, FEG, CHO.

FEG's gearing ratio likely to have risen significantly- room to optimise capital structure

As at 31 December 2014, FEG had cash of US$88.9 million vs total debts including notes payable of US$239.4 million, giving it a gross gearing and net gearing of about 0.82 and 0.51 respectively. The debts are mostly secured[i] against its existing vessels and leasehold office properties.

FEG had also previously disclosed its intention to fund the CHO takeover using bank borrowings and internal cash resources. Assuming a Loan to value ("LTV") ratio of 70%[ii], we estimate that an additional US$106.7 million of debts would have been added to date and the gross and net gearing would have ballooned to 1.10 and 0.80 times respectively despite the larger equity base due to consolidation of CHO's accounts. This is on par with its peer companies:

Figure 4: FEG's estimated proforma gearing is in line with its peers.

However, despite the seemingly manageable consolidated gearing, we note that all the debts (estimated at US$347.6 million) are now being carried on FEG's books. On the other hand, a large portion amounting to US$69.5 million of the combined cash balance is carried on CHO's debt-free books.

It is important to make this distinction, as while CHO is now majority controlled by FEG, they are fundamentally two separate listed entities each managed by its own board of directors. Cash carried on CHO's balance sheet for example could not be used to pay FEG debt or service FEG interest unless distributed upwards to FEG via say dividends. Thus, we believe that there is room for FEG to carry out a capital structure optimisation exercise and lower its own gearing, especially with the market expecting an interest rate hike later this year.

Strategic options for FEG

We believe FEG may undertake the options put forth below to optimise its capital structure:

Option 1: Gear up CHO’s balance sheet to repay borrowings at FEG

One possible option is for CHO to take on borrowings against its balance sheet and distribute the loan proceeds as well as excess cash on its books to its shareholders in the form of a special dividend. FEG can then use the dividends it receives to reduce its own borrowings, particularly those arising from financing the CHO offer.

As an illustration, we estimated that if CHO were to borrow an amount of US$75 million, secured on its fixed assets of US$196.6 million (taking into account revaluation of its vessels), it would be able declare a special dividend of almost US$125.0 million or S$0.24 per share, out of which US$108.4 million would go to FEG for it to repay its entire projected acquisition loan as well as associated costs.  Even with the special dividend payment, CHO would still be able to retain approximately US$19.5 million in cash as working capital. This would however lead to a cash leakage of US$16.6 million to minority shareholders of CHO.

Option 2: Inject FEG’s marine division into CHO

FEG’s marine division's operates a fleet of 22 offshore support vessels ("OSVs"), including accommodation work barges and multi-functional support vessels, that mainly service customers in the production phase of O&G projects. It has traditionally been a major contributor to FEG in terms of revenue and profit. See charts below:

Figure 5: Marine division is a major contributor to FEG's revenue and operating profits

The division is also FEG's most capital intensive and contributes the majority of the fixed assets in the group:

Figure 6: Marine division contributes the bulk of FEG's fixed assets.

We thus see scope for the division to benefit from a separate listing which would give it ready access to capital markets. In this aspect, FEG can take advantage of CHO's existing listing by injecting its marine assets into CHO. The consideration can be satisfied partly by cash and shares so as to maintain CHO's mandatory free float while freeing up capital at FEG to reduce its borrowings and to invest in other segments of its core businesses.

We note though that this proposal would be subject to higher execution risks: CHO minorities would have to approve the transaction given that it is an interested persons transaction and FEG would not be eligible to vote. 

Option 3: Privatise CHO by buying over remaining stake held by CHO minorities, possibly via a share swap

As opposed to Option 2, FEG management may feel that there is no need for FEG and CHO to both maintain their listing statuses. Indeed, having two listed entities would lead to additional unnecessary compliance costs, especially when FEG already controls 86.7% of the total outstanding shares of CHO. While CHO's existing free float is only 13.3%, buying out the remaining minorities may cost at least US$38 million even if FEG were to stick to the same terms of S$0.55 cash for each CHO share as per the recently concluded offer. With the estimated gross gearing levels of FEG already at 1.10, any additional borrowings used to fund this would not be ideal.

Hence, we think that it may make more sense for FEG to propose a full or partial share swap instead, effectively paying for the CHO shares held by minorities with new FEG shares. As an illustration, if we were to effect the share swap based on the current FEG price of S$0.27 per share and an CHO offer price of S$0.55 per share, Tan Pong Tyea would still be able to retain his controlling stake at above 50%. 

Figure 7: Tan PT would still retain majority control even with a full share swap to acquire CHO's remaining shares.

Other variants to the share swap option include those based on NAV, which could cost less for FEG as it is currently trading below its NAV of 33 US cts as at 31 December 2014.

A follow up privatisation offer though may need to be sufficiently more attractive that the previous offer to entice the remaining minorities to accept. This is, however, unlikely to take place within 6 months after the CHO offer closed on 27 February 2015 as the Singapore takeover code forbids a second offer to be made within this period on terms better than the preceding offer.  

Alternatively, FEG may acquire more CHO shares in the open market before it makes the follow up offer to acquire the remaining shares.

Other key developments to note

On 11 October 2013, CHO announced that it had commenced legal proceedings  in London against PDV Marina S.A. and Astilleros De Venezuela C.A. to recover outstanding charterhire amounting to approximately US$56 million. The  trial is set for 20 April 2015. As CHO had previously written down US$44.0 million worth of related receivables in FY2013, a positive outcome from the trial would provide a boost to both FEG and CHO's financial positions and share prices.

Recommendations

We think the successful takeover of CHO by FEG will be positive to both CHO and FEG in the long run in view of the potential operational synergies. FEG's share price, despite trading at just 5.2 times historical adjusted earnings, may continue to be depressed due to the current challenging operating environment in oil and gas. FEG's gearing could also potentially be a drag on earnings in an environment of rising interest rates.

As for CHO, any potential capital optimisation exercises by FEG to reduce its borrowings may lead to short or medium term price catalysts in the form of a special dividend or a further privatisation attempt by FEG. Both CHO and FEG could also benefit from a positive outcome in the impending trial taking place on 20 April 2015. We are positive on FEG's long-term prospects particularly if it manages to successfully integrate CHO's operations into its own but would prefer an exposure to CHO in view of both long term and short term potential upside.

Key Risks

Further deterioration in the O&G sector will negatively impact both CHO and FEG. FEG will be the more vulnerable of the two with the 5 jack-ups owned by its JVs set to be delivered over the next 1-1.5 years. With total debts likely to have hit US$347.6 million, FEG is also susceptible to rising interest rates.
Investors and CHO shareholders may also not be able to trade CHO shares freely with its free float currently at only 13.3%.

The intriguing but short shareholders' tussle over CH Offshore Ltd ("CHO") has put the spotlight squarely on Chuan Hup, an undervalued gem long known to value investors but yet attracts little to no analyst coverage. Following its decision to dispose of its entire 24.67% stake in CHO, Chuan Hup stands to reap a windfall of $95.7 million. Its share price has since reacted by adding 11% to close at $0.305 per share on 13 February 2015. With an extremely robust cash-rich balance sheet, key investment holdings in strong cashflow generating entities, prospects of a good dividend payout, we rate Chuan Hup as a good long term buy for investors with a possible short term price catalyst.

Background

Brief takeover tussle

On 9 February 2015, Falcon Energy Group Ltd ("FEG") announced that it will increase its offer for CH Offshore shares to $0.55 per share from $0.495 previously. On the same day, Chuan Hup announced its intention to accept the revised offer after initially rejecting the original and snapping up 0.91% worth of shares in the open market in an apparent attempt to put pressure on FEG. This is close to the 1% it can acquire in any 6 month-period before triggering its own takeover as Chuan Hup and Peh Kwee Chim, its controlling shareholder own more than 30.6% of CHO's total shares (although it was disclosed in the CHO offeree circular dated 8 January 2015 that including associates, this figure is around 35.1%) prior to the FEG offer.

This effectively ended a shareholders' deadlock that has been in existence ever since FEG acquired its original 29.1% stake in April 2010 from Bursa-listed Scomi Marine Berhad (n.k.a. Scomi Energy Services Berhad), who in turn had acquired the same stake from Chuan Hup back in 2005.

Potential Win-Win-Win

FEG finally managed to wrest control of CHO at a reasonable price after initially spending $143.5 million in 2010 to acquire its 29.1% stake at a much higher price of $0.70 per CHO share. The revised offer of $0.55 is at a slight discount to the estimated revalued NTA per share of $0.57 per CHO share (source: CHO offeree circular) as at 30 September 2014. CHO also has an ungeared balance sheet with net cash per share of around $0.13 per share potentially giving FEG flexibility to recapitalise the company and reduce its own upfront cost of funding the acquisition. We expect synergies to be derived from combining FEG's fleet of mainly accommodation barges and rigs with CHO's complementary fleet of AHTS vessels going forward. 

Shareholders of CHO get to exit their investments at a price that has not been reached for more than 4 years even as the share prices of almost all other oil and gas counters have plummeted. (see CHO historical price chart below) Even shareholders who chose not to accept the offer and remain as CHO shareholders can potentially benefit from the operational synergies as described above.

Figure 1: CHO last traded at $0.55 in 2010

Finally, Chuan Hup gets to cash in on its CHO stake for a tidy sum of $95.7 million and turn its focus on other investments amidst a weak current operating environment for CHO's oil and gas services business. Shareholders of Chuan Hup could even be in line for a special bonanza if the board of directors decides to emulate its feat of distributing a bumper 44 cts per share special dividend in FY2006 representing almost 100% of its $485.6 million cash proceeds from the disposal of its marine logistics business along with 49.1% stake in PT Rig Tenders Indonesia and the 29.1% stake of CHO shares to Scomi Marine. For comparison purposes, the $95.7 million proceeds should translate to about 10.2 cts per share if distributed fully. 

Chuan Hup and its treasure trove

Since its establishment in 1970 as a tug and service provider for PSA Corporation in Singapore, Chuan Hup has quietly grown under the guidance of co-founder Peh Kwee Chim into a diversified group with core interests in oil and gas services, property development and electronics manufacturing services. Post CHO disposal, the company is likely to focus its attention on the latter two while seeking out new investments.

PCI Ltd

Chuan Hup's electronics manufacturing business is carried out under SGX Mainboard-listed PCI Ltd (www.pciltd.com), which it successfully made its subsidiary (76.7% owned) following a mandatory conditional offer in May 2011. Despite operating in a tough and competitive industry, PCI has delivered at least 10 consecutive years of profits and has an enviable and uninterrupted track record of paying consistent dividends of at least 3 cts per share for most years in the same period with a total of 10 cts paid for the financial year ending 30 June 2014. 

Figure 3: PCI has maintained positive operating cashflows and high levels of cash for at least the last 7 financial years (Source: company)

PCI also has a very strong balance sheet with no borrowings and cash holdings of $52.9 million (US$39.1 million) as at 31 December 2014 after adjusting for considerations to be received and paid pursuant to its proposed disposal of the Jalan Ahmad Ibrahim property (announced 13 Feb 15) and acquisition of the Pioneer Road North property (2 Jan 15). This forms approximately 62% of its market capitalisation of $85.6 million based on the closing price of $0.43 per share, giving it an enterprise value of just $32.7 million and a very undemanding FY2014 EV/Ebitda of just 3.1 times.  At $0.43 per share, Chuan Hup's stake is worth $65.7 million.

Finbar Group Ltd

Chuan Hup’s other major investment in a listed company is in Perth-based Australian property developer and ASX-listed Finbar Group Limited (www.finbar.com.au), in which it holds a long term strategic stake of 17.5%. It should be noted that even though the stake is less than 20% and Chuan Hup could not equity account for Finbar's share of profits, it is actually the largest single shareholder in the property company.  

Finbar is a leading property developer in Western Australia, particularly Perth, and has a long established track record of 2 decades, having completed 58 projects worth A$2.8 billion.  It also has an impressive streak of having generated 8 consecutive years of net profit growth with an even longer run of increased dividend payments since FY2003. 

Figure 4: Finbar has an impressive track record of generating profits and increased dividends.

Despite being a property developer and consistently paying dividends, the company has also managed to keep its net gearing to a low level of just 7.3% as at 30 June 2014. As at the closing price of A$1.345 per share, Finbar has an attractive dividend yield of 7.4%.  Chuan Hup's stake is worth $56.3 million (A$53.6 million)

Property development in Australia

Chuan Hup currently has 2 property joint ventures with Finbar ("Australian JVs"):

• Symphony City, a 3-phase residential development to be built on the former Australian Broadcasting Corporation site located at 187 Adelaide Terrace, East Perth, Western Australia. The site was acquired by Chuan Hup in 2008 for A$37.6 million. Of the 3 phases (Adagio, Toccata, Concerto), Adagio has been fully sold, completed and earnings mostly recognised in FY2013. Earnings from Toccata (to be completed in FY2015) and Concerto (FY2017) will be recognised in the subsequent years.
• Unison, a residential development to be built on a plot of freehold land in Maylands Perth acquired by Chuan Hup in 2013 for A$16.7 million. The land acquisition was funded by sales proceeds from Adagio. The development consists of 347 residential apartments and 4 commercial lots to be launched over 2 phases, Unison on Tenth and Unison on Kennedy, to be completed in FY2016 and FY2017 respectively.

Under both JV agreements, Chuan Hup contributed the land and Finbar contributed the working capital necessary for the development. There should thus be no further foreseeable capital requirements for Chuan Hup going forward for these JVs. Profits from both developments will only be recognised upon physical completion and settlement of sold apartments.

Based on information from Finbar's website to date, Toccata has sold 68% of its units while Concerto's sales is at 46% (104 of 226 units) since marketing commenced in March and August 2014 respectively. Unison on Tenth has sold 32% of its units (54 of 167) since marketing commenced in early FY2015. 

With a book value carried at cost of just US$33.5 million ($45.4 million) for both Symphony City and Unison, Finbar’s impressive track record, we expect positive contributions from these two projects over the next 3 years despite the current challenging conditions in the Western Australia real estate market. For illustration, Chuan Hup registered a profit before tax of US$19.4 million over FY2013 and FY2014 for its property development segment primarily due to completion of Adagio.

Figure 5: Toccata, Concerto, Unison on Tenth. Sales figures as at September 2014 based on Finbar’s annual report although Finbar's website lists more updated figures. Source: Finbar

Other significant assets:

• A 32.5% stake in Security Land Corporation (SLC), a property developer in Philippines. SLC is majority controlled by Security Bank Corporation of Philippines, a US$ 2.1 billion company listed on the Philippines Stock Exchange, and has a joint venture agreement with Robinsons Land Corporation to construct a high-end condominium within the Makati financial district in Manila. Tower 1 and Tower 2 of the project, named Signa Designer Residences, were 84% and 44% sold respectively as at September 2014. SLC also owns an adjacent office block through which it derives regular rental income.
• Office units in GB building in Shenton Way, Singapore, acquired in November 2014 for $31.7 million as long term investments.

Valuation

Using sum-of the parts (SOTP) method, we derive at a conservative value for Chuan Hup of $0.432 per share. Our valuation pegs PCI and Finbar to their respective market valuations and the remaining assets conservatively at book value, which in the case of the Australian JVs is at cost. The valuation is supported by approximately $0.226 net cash per share, taking into account Chuan Hup's share of the PCI's cash hoard. This is, in our view, reasonable as Chuan Hup effectively controls the use of cash at PCI.

Figure 6: SOTP computation

Recommendation

We believe there is deep value embedded in Chuan Hup which should appeal to long term value investors. In addition, Chuan Hup's shareholders could also benefit in the short term should sales proceeds from the disposal of CHO shares be paid out as special dividends in a repeat of the disposal to Scomi Marine in 2005. The shares are currently trading at a 29.4% discount to its intrinsic conservative SOTP value of $0.432 per share with good downside protection provided by its adjusted net cash per share of $0.226 as well as a decent dividend yield of 3.3%. We are buyers at this price. 

Key Risks

The strengthening US dollar against both the Australian and Singapore dollar has resulted in Chuan Hup being hit by significant foreign currency related losses in recent quarters. We think that this could be a key concern going forward. The weakening Western Australian real estate market could also pose challenges to both its Australian JVs, although this is mitigated by the Australian JVs being carried on its books at cost.  

(All preceding amounts in SGD unless stated, USD:SGD X-rate of 1.3550 and AUD:SGD X-rate of 1.0520 assumed)