Bharti Shipyard and Great Offshore

Despite the sentiment improving in the last couple of months, the outlook for the shipbuilding sector continues to be weak. Though the Asia Pacific Shipbuilding Index, which measures the orders for shipyards for leading shipyards in Asia, has been on an uptrend over the last couple of months, it is still long way away from its value last year. While the index is up 38 per cent since March, and 10 per cent since April, the drastic drop in trade and the demand for new ships has meant that the index is still 97 per cent down since May 2008. The global shipbuilding industry is bogged down by cancellations and delays due to lack of credit and stiff financing terms.

For Bharati, of the total order book of Rs 5,093 crore, the unexecuted part (orders booked minus revenues booked) is about Rs 3,300 crore to be completed in the next two years. The issue for the company has been the lack of large incremental orders. Over the last five months, the company has bagged only a single large order of Rs 281 crore from the Ministry of Defence. While the company says that there have been no cancellations so far, analysts are, however, divided over the quantum of cancellations Bharati is likely to face. While some analysts believe that customers might not want to forego the 20 per cent advance given to the shipbuilder, others say that the tight credit situation and dip in demand would mean a cancellation to the extent of 15 per cent (Rs 500 crore) for the company. This could keep its yards idle and add to its interest burden.

Offshore demand

But, the situation isnt as grim for Great Offshore. Thus far, the offshore business has been less affected than the tanker and dry bulk business as the latter suffers from an oversupply situation. For instance, the Baltic Dirty Tanker and Baltic Dry indices had declined between 85-95 per cent from their peak in 2008; only the Baltic Dry index has risen recently, but is still down two-thirds from the peak. However, the lack of fresh supply in the near term means that charter rates for the offshore business are expected to be stable. Though hiring rates for rigs have halved over the last one year to about $110,000 a day, this will not affect Great Offshore as most of its contracts are long term in nature and have been in place since 2006. In fact, analysts believe that the company could get better rates for three of its vessels which are up for renegotiations in FY10 as the price is expected to be higher than those it got earlier. However, the demand for offshore vessels and day rates going ahead will depend on the price of oil, which recently has shown an upward bias. Analysts believe that if the same stabilises at around $70-$80 to a barrel, exploration activities will increase, boosting hiring rates.

Valuations

While valuations for Great Offshore which trades at 5.26 times its FY10 estimated earnings and Bharati Shipyard (2.29 times its FY10 numbers) are reasonable, the outlook for the shipbuilding and offshore services in the short term is not looking good. At the offer price of Rs 344 (which is a 10 per cent discount to the current price of Rs 380), the deal pegs the enterprise value (EV) of Great Offshore at Rs 3,200 crore translating into an EV/EBIDTA of 5.5 times for FY10. Its larger peer, Aban Offshore, which is run into a spot of bother after its Sinvest acquisition, trades at 6.3 times. In this context and the strategic benefits for Bharati, the deal is not expensive. Thus, dont be surprised if new suitors enter the fray and bid up the price, in which case Great Offshores investors will stand to gain. Despite cheap valuations, the outlook for Bharati does not look too bright. If you possess Great Offshore shares, hold on to them.

If the open offer by Bharati Shipyard (Bharati) for Great Offshore goes through, the countrys second largest ship maker would have sewn itself a good deal. Bharati, which is already the largest shareholder in Great Offshore with a 14.89 per cent stake, has announced an open offer a week ago to acquire a further 20 per cent stake in Great Offshore at Rs 344 a share. If successful, Bharatis stake will increase to 35 per cent and will help it to forward integrate its business.

Good deal

While there are no major benefits for Great Offshore, how does it help Bharati to buy a stake in Great Offshore? Analysts believe that there are three reasons for this. First, Great Offshore, which currently accounts for 30 per cent of Bharatis order book will route its future requirements, which includes the replacement of an ageing fleet and repairing the existing ones, through Bharati. With 70 per cent of Bharatis revenues coming from offshore vessels, an assured captive demand will mean revenue visibility and keep its production lines occupied. Second, Bharati will be able to derisk and reduce the impact of a slowdown in the shipbuilding business. Finally, the combined net debt of Bharati (Rs 700 crore) and Great Offshore (Rs 1,900 crore) and resulting high interest cost of Rs 56 crore and Rs 110 crore respectively in FY09 could be brought down. Given the current environment, Great Offshore is relatively better placed in terms of cash flows. Bharati might lean on Great Offshores strong cash flows which were Rs 389 crore vs Bharatis Rs 140 crore in FY09.