This was not supposed to be such a quick follow-up post to my just concluded Analysis of Ezra’s FY 2009 financials, but certain corporate actions made by the company necessitated my immediate action and attention and which compelled me to act.
Securing of US$1 Billion Chim Sao FPSO Project by EOC
Immediately after my posting on Wednesday morning October 21, 2009 of Part 2 of my analysis and rationale for partial divestment, Ezra dropped a bombshell by announcing that its 48.5% associated company EOC had clinched the much talked-about Chim Sao FPSO deal, which was worth US$527 million for the first 6 years and US$477 million assuming an option is exercised to continue for another 6 years. Thus, the total value of the contract is US$1,004 million over 12 years, or if smoothed out equally, will represent revenues (not profits) of about US$83.7 million per year. The worrying aspect of this announcement is how EOC are going to fund the conversion of a deadweight tonne oil tanker into an FPSO as they are already very highly geared (2.31x as at August 31, 2009). It immediately became clear to me that EOC (through Ezra) would have to do some fund-raising to be able to take on this project, and I was proven right (see next section on Issuance of Convertible Bonds).
Note that although the press releases from Ezra and EOC both tout the value of the contract and talk about stable revenue contributions and asset utilization for at least the next 6 years, I actually analysed the situation and came up with a different perspective:-
1) Assuming additional revenues of US$83.7 million per year, and assuming a very healthy net margin of 20% (gross margin for Offshore Support Services is 38% as at August 31, 2009, so 20% is reasonable to assume for net margin, albeit a little optimistic), this means an additional US$16.74 million worth of profits accruing to EOC each year. Since Ezra owns only 48.5% of EOC, this means they only recognize an additional US$8.12 million per year on a Group basis. This only constitutes about 11.6% of their core FY 2009 net profit, and thus cannot be considered very significant. This is because of the risks to be factored in when taking on a project of such massive size (see point 2).
2) The first FPSO deal clinched by Ezra and announced in 2006 experienced many delays and hiccups as first gas took very long to achieve, and in fact it was only today (October 22, 2009) that Ezra announced that the client had commissioned and accepted the FPSO, with almost a year of delay between deployment to production of first gas. Originally, it was announced that Lewek Arunothai would contribute to 1Q 2009 revenues; but this has since been pushed back all the way to 1Q 2010. This demonstrates the technical difficulty of operating an FPSO, and for the Chim Sao Project the complexity may again lead to delays of a similar nature.
3) Note that EOC mentions that the FPSO would be owned by “4 entities”, though it does not give details of these entities and whether they are part of Ezra Group. Assuming that the entities are external parties, this may imply that EOC may only share up to 25% of the revenues accruing from the FPSO. This makes Point 1 assumptions drop by 75% to just about US$2 million accruing to Ezra Group per year.
4) The EOC announcement also mentions that EOC and a Vietnamese partner will be operating the FPSO, which essentially means the risks are borne by EOC in terms of operational capabilities and execution. Note that a delay similar to the one experienced by Lewek Arunothai could result in additional costs and damages should the client decide to pursue legal action (which I assumed did not happen, but one cannot assume the same for Chim Sao Project).
Viewed from this perspective, it would appear that the deal may not be as lucrative as envisaged, especially if it comes from the angle that the revenues accrued to Ezra Group may not be significant (pending more clarity on the 4 entities and shareholding structure for the new FPSO), but that EOC is taking on a large portion of the costs and risks relating to the financing and operation of the FPSO. There is also concern from yours truly on EOC’s ability to finance an FPSO since its gearing was so high, and I was frankly very surprised that they clinched the deal, as during the EGM I had brought up the point to Management that I did not think EOC would be able to handle the second FPSO as it was highly geared (they did not give me a reply on this).
Issuance of 5-Year 4% Convertible Bonds Worth US$100 Million
As predicted, Ezra announced on the morning of October 22, 2009 that it would be issuing (through DBS), 5-year 4% convertible bonds worth US$100 million, presumably to fund the FPSO as well as for expansion and general working capital purposes. The details can be found in the release on SGXNet, so please check it out on your own. Effectively, they argued, the convertible bond would lower their gearing when converted (conversion price set at S$2.50 per share) to just 8%, and “strengthen their Balance Sheet”. Perhaps they also forgot to mention that in the case where the bonds are NOT converted, they represent even more debt being piled on to their books (Ezra is now taking up the gearing since EOC is already massively over-leveraged). And even if they are converted, the only reason gearing drops is because the share capital base increases by 55.86 million while debt drops as a result of the conversion. So in effect shareholders have to choose between even more debt (and associated interest expense of 4% per annum) or 8.5% dilution based on the existing issued share capital of 658 million shares.
Personally, I feel that this may not be the last time Ezra heads to the capital markets for fund raising, and it is making me very uncomfortable as to how the Group persistently and consistently raise money through financing activities and not operating activities. Their cash burn rate is basically very high and the Group seems to thrive on issuance of shares and increasing their debt. I had once erroneously assumed that Ezra would be able to achieve stable positive operating cash inflows once they had stopped their fleet expansion and tied up their long-term charters; but it seems that this was not to be. Their relentless focus on expansion by taking on the second FPSO and also the purchase of Ice Maiden confirms that more dilutive fund-raising is on the cards, and probably a lot more debt will be loaded on both EOC and Ezra’s Balance Sheets. This is an unacceptable situation to me as an investor.
Other Pertinent Factors
As mentioned in my last post analysing Ezra’s financials, the receivables level has remained persistently high for the last few quarters which shows that revenues are recognized aggressively, while cash collections have taken a back seat. This is a very alarming trend and may indicate some problems with collection even though, as Ezra states, their clients are reputable multi-national oil companies and oil majors who would (presumably) have no problems in paying on time. As their Energy Services Division was the fastest growing division for FY 2009, and since most of the ballooning in receivables came in during FY 2009; it would be safe to assume that this division had the longest credit terms extended, and it is currently doubtful as to whether these receivables are collectible.
During the EGM, Management had also mentioned that their Vung Tau yard would take a back seat and would be left as a Greenfield project. This was somewhat surprising as my understanding was that Saigon Shipyard was already fully utilized and excess capacity for fabrication contracts could be channelled to the new yard instead. This could imply that there is no urgency to build up their new yard, or there is a lack of funds to develop this yard further without once again tapping the secondary market.
Ezra’s Business Model – High Revenue and Profit Growth at the expense of Positive Operating Cash Inflows and Balance Sheet Strength
Ezra’s business model is inherently as described in the title above – boasting high CAGR growth in revenues and profits but most of the time neglecting their Balance Sheet and Cash Flows. Frankly, this had not changed since FY 2005 when they conducted their sale-and-leaseback transactions to free up cash and quickly expand their fleet, and they are now finding ways to get cash from the markets and from loans once again. The old-fashioned method of funding growth through recurring operating cash inflows seems to have been forgotten in their relentless quest to secure higher profits and revenues. This is an untenable situation for me as an investor and my original rationale for investing in Ezra (with the flawed assumption that it would cease aggressive asset buildup and instead build up a war chest of cash) is now gone.
Full Divestment and Lessons Learnt
As a result of the explanations above, and coupled with the discomfort I felt during the EGM, I have fully divested my position in Ezra today at a price of S$2.05, booking a gain of 226% of the remaining portion of my stake (the previous batch was sold at S$2.01 on October 16, 2009). The total realized gain on divestment of Ezra is around 222% for my entire stake, and taken over 4 years this amounts to approximately 55.6% per annum. This will be fully reflected in my month-end October 2009 portfolio review.
Notwithstanding the fact that I had booked a gain on the divestment of Ezra, I will still classify Ezra as an investment mistake and model “case study” on the type of companies to avoid investing in; due to the fact that such an aggressive model does not constitute a prudent value investment and also the fact that leverage is so high (blended gearing of EOC + Ezra) makes this a very risky investment whether during good times or bad. There is much to learn as I mull over my efforts and analysis over the last four years; including analysing all quarterly reports, reading all Annual Reports, attending all AGM/EGM and speaking to key Executives of the Company. Another minor point I would like to bring up is also of the “marketing” and “glossy” nature of the press releases churned out by the Company, similar to those which I mentioned for Swiber (which I had divested in August 2009). A lot of the positives and optimism has been factored into Ezra’s share price at this point in time, and it is trading at a dangerously high valuation considering there are so many risks in execution and also with a weak Balance Sheet and Cash Flows.
As a result of what I had learnt, it would seem that I had been speculating rather than investing as my original premise for investment was itself flawed. In short, I was mistaking myself to be investing when actually my grounds for investing did not conform to value investing principles. For this, I am regretful and will endeavour to learn from this mistake and avoid repeating it when analysing future companies for investment. More focus will be placed on Balance Sheet strength, net cash position and recurrent operating cash inflows instead of just Profit and Loss and margin numbers.
Acknowledgements
I would like to express my gratitude to Donmihaihai and d.o.g. (initials for “Disciple of Graham”) for highlighting salient aspects of Ezra’s Balance Sheet and Cash Flows to me and which helped to complement my own research into Ezra. Donmihaihai’s post on Ezra can be found here, while d.o.g.’s take on Ezra is detailed in this link, in which I had also contributed my thoughts, views and opinions. I humbly accept constructive criticism for making this post, but be warned that any post which constitutes troll behaviour will be immediately and irrevocably deleted without further warning.
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