KS Energy: Drilling and capital equipment business provide support

Results in line with expectations, except distribution business. KS Energy Services Ltd (KS Energy) reported a 35.9% YoY fall in revenue to S$128m and a 39.5% drop in net profit to S$13.7m in 2Q09. Revenue from the drilling services and other business rose 30.6% QoQ partly because two land rigs (Discoverer 2 and 4) commenced operations and the KS Titan-2 delivered its maiden revenue. This accounted for 50% of our fullyear estimate but contributions from the distribution business accounted only about 45% of our estimates with slower demand in the oil and gas industry. Lower steel prices also affected selling prices. The group also reported an additional S$4m insurance claim for KS Titan-1's loss after proceeds of S$9m in 1Q09. 1H09 net profit accounted for 50% of our fullyear estimate.

Warrants issue oversubscribed. The group announced a 1 for 4 warrants issue in June this year which generated S$16.8m cash to increase financial flexibility and support working capital needs. It was 124.36% subscribed, and management is encouraged by the results of the issue. Though the warrants are currently out-of-the-money, they may be exercised six months after issuance, and have one and a half year's expiry.

Updates on KS Endeavour. KS Endeavour, a Super M2 design offshore rig, will be delivered in end 09. This is the only asset on KS Energy's fleet that is not contracted out yet. Charter rates have definitely fallen with the dramatic fall in oil prices, but have stabilized in recent months with oil prices trending up from its low of about US$30 to about US$69 now. When asked about prevailing rates in the market, management gave a range of about US$110,000-US$120,000/day.

Maintain HOLD. As mentioned in our earlier report, KS Energy's fixed charter rates and existing contracts will serve it well during this downturn, but its distribution business may continue to feel the impact of reduced capital expenditure by oil companies. We have revised our revenue assumptions for the distribution business, which is now about 17% lower. We are encouraged to see that recurring profit can be provided by the drilling and capital equipment business but till we see a recovery in the demand of the group's products in the distribution business or the emergence of additional growth drivers, we maintain our HOLD rating and S$1.36 fair value estimate on the stock.

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KS ENERGY - Rights to commence trading - Impt Date

(I) Rights to commence trading : 15 July 2009

(II) Last date for trading of Rights in the Ready and Unit Share Markets : 23 July 2009

(III) Last date and time for acceptance, renunciation, excess application and payment : 29 July 2009 (ATM: at 9.30 p.m.) (Form: at 5.00 p.m.)

(IV) Rights to cease trading in the Buying-In Market : 30 July 2009

KS Energy - Adjusting for risk and warrants

KS Energy (KSE) announced on 4 June 2009 that it was offering warrants on a one-for-four basis at S$0.20/each. The warrants have a S$1.40 conversion strike price and a conversion period from 7-24 months after issuance.

In our opinion, the company’s issuance of warrants is an unusual choice for raising capital, as 1) it will not immediately raise a significant amount of capital (S$16m-18m in net proceeds from the warrant issuance), and 2) further capital-raising from warrant conversions is uncertain given that the warrants are ‘out of the money’. In our opinion, the warrant issuance is to improve the company’s working-capital liquidity, rather than prepare the balance sheet ahead of any imminent corporate action (eg, an asset acquisition).

We have made some modest adjustments to our FY09-13 balance-sheet and cash-flow assumptions, but no changes to our FY09-13 net earnings forecasts. Our EPS forecasts are also unchanged, as the warrants are currently anti-dilutive. Valuation

We have raised our six-month DCF-derived target price to S$0.92 from S$0.72, due mainly to a reduction in the assumed WACC, to 12.4% from 16.0%. The reduced WACC reflects investors’ shift away from the extreme risk-aversion that was evident from equity valuations in late-2008.Catalysts and action

KSE’s stock has risen significantly since the 28 April 2009 price of S$0.715 on the back of higher crude-oil prices and equity-market levels. However, we think that the company’s fundamentals should continue to be challenged from 2009-11 due to downcycles in jack-up and parts-distribution industries, despite the rebound in crude-oil prices to more than US$70/bbl from US$50/bbl as at 28 April 2009.

From an earnings perspective, KSE is theoretically ex-growth in FY09 and FY10 since it does not have a significant amount of equipment up for new contracts until late 2010. The company may see all four of its jack-ups come up for new contracts in late-2010 and 2011, making the state of the jack-up market very important. We expect jack-up day-rates to remain soft from 2010-11 due to a significant overhang of idle global jack-up capacity.

According to Daiwa’s view, the Straits Times Index and crude-oil prices are both currently more-than-fairly-valued and are at risk of a price correction over the next six months. We expect KSE’s share price to underperform the Straits Times Index if stock indices and/or crude-oil prices decline.

KS Energy: Fixed charter rates lend visibility in an uncertain environment

Volatility persists in oil prices. The price of crude oil has risen more than 50% this year, hitting a high of about US$73/barrel on 12 Jun 09. The correlation between oil and equity prices has also increased significantly since the financial meltdown last September. With an unwinding of the Armageddon scenario and improving investor sentiment, global risk appetite increased. This and various concerns about the strength of the USD with the huge amount of quantitative easing underway led to a weaker dollar, fueling higher oil prices. However, crude oil price seems to be facing some resistance currently with fatigue in the equity market, falling to about US$68/ barrel two days ago.

Looking for a real demand for oil. Demand for oil ultimately depends on economic recovery, and economic indicators are showing more positive signs in general. OECD composite leading indicators point to a slower pace of deterioration in most of the OECD countries with possible troughs in countries like China and the UK. The US Conference Board leading index of consumer expectations also improved significantly from a low of 50.5 in February this year to 69.4 last month. However, a proportionate increase in the demand for crude oil and oil products seems elusive. Demand from OECD countries for oil products remains low (Exhibit 1), though some form of stabilization is expected, if leading indicators sustain their upward trend.

Fixed charter rates. Jack-up day rates have been affected by lower oil prices, but KS Energy's contracts are based on fixed charter rates, so lower spot rates are unlikely to impact the group adversely for now, unless oil prices trend significantly lower and customers negotiate for lower rates. Things should be looking better for the group's customers with the recent recovery in oil prices.

Maintain HOLD. KS Energy's fixed charter rates and existing contracts will serve it well during this downturn, but its distribution business may continue to feel the impact of reduced capital expenditure by oil companies. As the current level of oil price is still unable to induce a full recovery in overall E&P activity and markets remain relatively volatile, we maintain our HOLD rating and S$1.36 fair value estimate on the stock. However, the inventory restocking of commodities by China and possible oil speculation by institutions may contribute to higher oil prices despite soft fundamentals, which would lend support to the stock price.

KS Energy Services Ltd: Rights issue of warrants

Rights issue of warrants. KS Energy Services Ltd (KS Energy) has proposed to undertake a renounceable non-underwritten rights issue of up to 92.747m warrants at an issue price of S$0.20 for each warrant. Each warrant carries the right to subscribe for one new ordinary share at an exercise price of S$1.40 on the basis of one warrant for every four existing ordinary shares held by entitled shareholders, fractional entitlements disregarded. Several key shareholders have given their irrevocable undertakings to subscribe for the entitlements.

Previous agreements. The group has previously entered into a subscription agreement (dated 6 Jun 07) with Sovereign Assets S.A pursuant to which warrants were issued; the full exercise will amount to an issuance of 9m shares (subscription shares). There are also three bond purchase agreements (dated 23 Jul 07) with Centar Investments (Asia) Ltd, Stark Asia Master Fund Ltd and Stark Master Fund Ltd pursuant to which convertible bonds were issued; the full conversion will result in an issuance of about 25.3m new shares (conversion shares).

Proceeds for general working capital. Including the subscription shares and conversion shares, 92.747m warrants will be issued, assuming full subscription and exercise of the current warrants issue (maximum subscription scenario). This will raise about S$18.2m in net proceeds from the warrants issue. A minimum subscription scenario outlined by the group delineates that about 84.2m warrants will be issued, and the estimated net proceeds will be about S$16.48m. KS Energy intends to use the net proceeds for general working capital.

Maintain HOLD. Although the upfront estimated net proceeds does not seem very substantial compared to the group's cash level (about S$70.6m as at 31 Mar 09), proceeds from the exercise of warrants are considerable (about S$118m assuming full exercise and minimum subscription scenario). This will provide additional financial flexibility to the group (as of 31 Mar 09, ST debt: S$145.9m, LT debt: S$200m, net debt-to-equity ratio: 0.69x). Together with Dubai-based Dutco, the group may also look into acquiring assets during this downturn. We are raising our fair value estimate to S$1.36 (prev S$1.10) based on 9x FY09F PER for the distribution business and 10x peg for drilling and related businesses due to the current re-rating of the sector, but maintaining our rating at HOLD.