TSC Offshore Group (TSC 海洋 ) Ready to go

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1 . Equity Research Oil & Gas Equipment/ China INITIATE: BUY TP: HK$4.50 TSC Offshore Group (TSC 海洋 ) HKEx Code: HK / Price: HK$2.81 Ready to go Key Data Close Price (HK$) Month High (HK$) Month Low (HK$) M Avg Daily Vol. 2.7 Issue Shares (mn) Market Cap (HK$ mn) 1,834 Free Float (%) Net debt/ equity (%) (0.01) Major Shareholder(s) Global Energy (24.4%) Source: Company data, Bloomberg, OP Research Closing prices are as of 31/12/2009 All figures are subject to rounding Dec HK MSCI CHINA Feb-09 Company background Apr % The Group is principally a total solution provider for offshore rig equipments. It also provides individual rig equipments, expendable parts and consultancy services. KEY POINTS: A total solution provider for offshore rig equipments. TSC Offshore ( TSC ) has become a total solution provider for offshore rig equipments through horizontal acquisitions and vertical alliances. It is now one of the three total solution players in the global offshore rig equipment market, where entry barrier is high and growth potential is good. Sensible strategy for significant growth. By offering globally competitive products at China price and speed, we believe TSC has formulated a clear and sensible strategy to erode the market shares of global leaders NOV and Aker. Given that TSC currently has only ~2% of global market share, even a small increase in market share will translate into significant growth, we think. Competitive edges: 1) TSC could price 10-25% lower than its competitors with lower cost of detail engineering and manufacturing in China; 2) TSC shortens 10-15% delivery time by: (a) using the world s largest crane from its strategic partner; (b) utilizing the versatility of Chinese labor; and (c) reducing transportation time with proximity to China s shipyards. Other favorable factors. 1) Capable management; 2) strategic relationship with CIMC; 3) government support; 4) customers need to counter the NOV+Aker duopoly; Key risks: 1) short history; 2) integration risk; 3) adverse oil price movement. BUY. We expect TSC s net profit to grow by 38% CAGR during FY09-FY13. We initiate with BUY and a TP of HK$4.50, based on approximately 0.5x FY10F PEG, giving a 60% upside. Eric Kwok Oriental Patron Securities Ltd eric.kwok@oriental-patron.com.hk Exhibit 1. Investment Summary F 2010F 2011F Revenue (US$m) Growth (%) Net Income (US$m) Growth (%) Gross margin (%) Profit margin (%) ROE (%) EPS P/E (x) P/B (x) Source: Company; OP Research

2 Table of Content What does TSC do?... 3 Investment Highlights... 4 Company Background... 6 Industry Analysis TSC s Strategy TSC s Vertical Alliance Other Favorable Factors Management Conclusion: Earnings Outlook Valuation Risks Financials Page 2 of 25

3 Oriental Patron Research - Equities What does TSC do? Answer: TSC is a total solution provider of offshore rig equipments, which are mostly located above the rig platform and account for ~1/3 of total rig cost. Exhibit 2: A semisubmersible rig (for illustration purpose only) What? Who? How Much? Equipment TSC 1/3 of total rig cost Platform & structural steelworks Shipyard 2/3 of total rig cost Rig Design Design Design Company Source: OP Research; Company Page 3 of 25

4 Investment Highlights Rising demand for offshore equipments. Offshore has been the main source of growth for global oil production and accounted for half of oil discoveries in the last 20 years, according to Rafael Sandrea of IPC Petroleum Consultants, e.g. the giant fields discovered off the coast of Brazil. For China, much of the increase in oil output in the next five years will come from the South China Sea, according to OPEC World Energy Report As such, we expect growing demand for the offshore rig equipments provided by TSC. According to The World Deepwater Market Report by Douglas Westwood, deepwater expenditure in will be 36% higher than the preceding five year period. Of these, 24%, or US$8.4bn will go to rigs in Offshore rig market is difficult to enter, but TSC is now in the game. Given the sophisticated technology requirements and high cost of operation in the complex offshore environment, barrier of entry is high. As such, there used to be only two total solution providers globally - NOV of the US (est. 70+% market share) and Aker Solution of Norway (est. 20+% market share). With the acquisition of Global Marine Energy Plc ( GME ) in 2008, TSC has become a total solution provider with the capability to provide 75% of rig equipments in-house. GME, which has 25+ years industry experience and supplied equipments to 23% of the world s semisubmersible rigs, also provides TSC with a most valuable ticket to the game a proven track record. A winning strategy: global technology at China price & speed. With the aforementioned acquisition of GME and its own 7 production bases in China, TSC is able to offer globally competitive products at 10-25% lower prices and 10-15% shorter time: Cost advantage arising from lower cost of detail engineering and manufacturing as the wage level of Chinese engineers and manufacturing workers are 80% lower than that of the US and as the cost of land, raw materials and overheads are generally lower. Speed advantage arising from: 1) the world s largest crane (20,000 mt) provided by Yantai Raffles Shipyard ( YRS ), a strategic shareholder with 7% interest in TSC, enabling parallel production instead of sequential production; 2) versatility of Chinese labor force; 3) shorter transportation time to ship the equipments from its China plants to Chinese shipyards for final rig completion, as China is the world s largest shipbuilding country. Strong vertical alliance. The aforementioned partnership with downstream player YRS, which is the No.1 rig builder in China, has helped TSC to obtain orders worth US$106m in 2007 (TSC s FY08 turnover was US$160m). The company also benefits from alliance with upstream rig designer, Friede & Goldman ( F&G ), in which TSC has 7% equity interest. F&G is the No.1 rig designer globally with 26+% share of the global jack-up and semisubmersible design market. Partnership with F&G helps TSC to design and make its equipments more effectively and efficiently. Page 4 of 25

5 Strategic relationship with CIMC helps to secure government support. China International Marine Containers (Group) ( CIMC ), a leading maker of containers and trailers, holds 8% direct interest in TSC. As CIMC has proposed a General Offer for YRS, CIMC s stake in TSC may rise to 15%. CIMC is one of the eight companies granted approval by the government to enter the offshore market with the intention to become a leading offshore rig builder. We believe TSC s strategic relationship with the government-backed CIMC will help it to secure government support, as explained below. China going offshore and nurturing domestic players. As mentioned above, China is actively developing its offshore resources. For example, CNOOC, the largest offshore producer in China, has announced plans to spend RMB bn in the next years to develop the South China Sea fields. To support these development, the government is offering a wide range of financial (tax/investment/credit), technical (R&D) and market development policy supports. As the only domestic total solution provider for offshore rig equipments, we believe TSC will benefit from these policies. Capable management. The management of TSC impressed us as a group of people with extensive domestic and international industry experience, with a strong ambition to develop the company into a global leader, and with the ability to execute, as evidenced by the company s rapid growth in the past few years and the piecing together of a clear and sensible strategy. Significant growth potential. At present, TSC has only ~2% market share. As such, even a 1% gain in market share would translate into 50% topline growth. To illustrate the growth potential: We assume rig capex in 2013 to be US$7.0bn, ~15% below the forecast by Douglas Westwood. If TSC s market share were to increase to 7% in 2013 (a conservative assumption given TSC s sensible strategy), the company s turnover could rise to US$500m. Given its cost advantage and the low degree of competition in the industry, assuming a conservative 10% net margin, TSC s net profit could rise to US$50m in FY13, representing a 5 year CAGR of 38%. Valuation. We expect TSC s net profit to fall by 25% to US$8m in FY09 before rising by 119% to US$17m in FY10 and by 46% to US$25m in FY11. The company is currently trading at 14x FY10F P/E, or 0.3x FY10F PEG. We think the market has yet to recognize TSC s good growth potential because of the specialized nature of it business, as well as its relatively short listing history on the Main Board. We initiate BUY with a TP of HK$4.50, based on approximately 0.5x FY10F PEG, representing 60% upside potential. Page 5 of 25

6 Company Background Exhibit 3: Corporate milestones History and background. The name of company, TSC Offshore, stands for an abbreviation of Total Solution Company for Offshore equipments, according to the management. Founded in 2001 as a manufacturer of rig electric control systems, TSC gradually expanded its product line to provide other rig equipments. It was listed on the Hong Kong GEM board in November 2005 under the name of EMER International. In January 2008, its name was changed to TSC Offshore. Following the acquisition of AIM-listed GME in July 2008, the company became a total solution provider. On 5 June 2009, the company transferred its listing to the Main Board. Commenced business in Xian as a rig-related electrical equipment manufacturer Set up TSC (Qingdao) Started manufacturing mud pump expendables Established TSC (USA) to expand to US market Started developing global network, extending to geographical reach to Brazil, India, Middles East, Singapore in following years Set up 1 st production facility in Qingdao EMER was listed on the GEM of HKEx YRS, Friede & Goldman became strategic investor Acquired Zhengzhou production base Became major shareholder of GME Completed the key strategic acquisition of GME group and expanded the product lines to include rig mechanical handling system and deck cranes EMER changed name to TSC Offshore CIMC became strategic investor Acquired 2 nd Zhengzhou production base (GEAR) and expanded jacking system product line Established the 2 nd production base in Qingdao to manufacture offshore capital equipment 2009 Transfer of listing to the main board of HKEx Source: Company Page 6 of 25

7 Exhibit 4: Revenue by segment Products and services. TSC s business is grouped under four categories: 1) Rig turnkey solutions: Offering a package of equipments with additional engineering and designing services. The segment accounted for 29% of turnover and 64% of segment profit (before unallocated expenses) in FY08. We expect the importance of this segment to rise in the future as the company vies for a bigger share of the total solution market. 2) Rig products & technology: Offering individual rig equipments, including drilling equipment such as mud pump; mechanical handling systems such as pipe handling system; and rig electric control and drives. The segment accounted for 60% of turnover and 29% of segment profit in FY08. 3) Oilfield expendables and supplies: Offering several thousand different expendable items such as liners and pistons used in rig daily operations. The segment accounted for 11% of turnover and 5% of segment profit in FY08. 4) Consultancy services: Offering rig inspection, engineering consulting, marketing consulting, and maintenance and repair services. The segment accounted for 0.5% of turnover and 2% of segment profit in FY Consultancy services 2% Rig products and technology 50% Oilfield expandables and supplies 11% Consultancy services 0% Rig products and technology 60% Oilfield expandables and supplies 48% Rig turnkey solutions 29% Source: Company Exhibit 5: Profit by segment (before unallocated expenses) Oilfield expandables and supplies 5% Consultancy services 2% Rig products and technology 29% Rig turnkey solutions 64% Source: Company Page 7 of 25

8 Business growth. During FY04-FY09, TSC s revenue grew by 88% CAGR from US$13m to US$160m, while its net profit grew by 31% CAGR from US$3.5m to US$10.3m. In 1H09, TSC made a net profit of US$5.9m from total revenue of US$70m, up 55% and 7% yoy respectively. Exhibit 6: Revenue and profitability (FY04-FY08) US$m Revenue Source: Company; OP Research US$m Net Profit Source: Company; OP Research Exhibit 7: 1H09 Results US$m H08 1H09 Turnover Net Profit Net Margin 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Source: Company; OP Research Geographical breakdown. In FY08, China, Singapore and N. America were the top three markets, contributing 35%, 23% and 23% of total revenue respectively. S. America contributed 9%. Europe & others contributed 10%. Exhibit 8: Geographical revenue breakdown 2008 Exhibit 9: Geographical revenue breakdown 1H09 Europe & others 10.0% Singapore 23.0% S. Ame 8.8% Source: Company; OP Research N. Ame 22.9% PRC 35.3% Europe & others 13.2% Singapore 19.4% S. Ame 12.3% Source: Company; OP Research N. Ame 17.6% PRC 37.5% Page 8 of 25

9 Cost structure. Raw materials, engineering costs and overheads account for 87%, 8% and 5% of cost of sales respectively. Of all the raw materials, TSC produces 20% in-house and procures 80% from outside. PRC vendors account for 60% of outside purchases while overseas vendors account for 40%. Page 9 of 25

10 Industry Analysis Long-run oil price supported by growing global energy demand. According to International Energy Outlook 2009 published by the US Energy Information Administration ( EIA ), world liquid fuels consumption (mostly oil) is expected to rise from 85m barrels per day in 2006 to 107m barrels per day in More than 80% of the growth will be driven by growing demand from non-oecd countries, especially China, India and the Middle East. Supported by growing demand, EIA expects average nominal world oil price to rise to US$189 per barrel in 2030 in its reference case, equivalent to US$130 in 2007 real dollars terms. EIA believes that the impacts of current economic downturn on petroleum demand are likely to be short-lived. It also expects national economies and oil to begin recovering in Exhibit 10: World Oil Prices in Three Cases Source: EIA Growing dependence on offshore oil production. While onshore oil reserves have been explored and developed for over 140 years, offshore oil production has a short history of ~60 years. Begun in the early 1940s, offshore crude oil production has grown to account for one third of global oil production volume in According to Rafael Sandrea of IPC Petroleum Consultants, offshore has been the main source of growth for global oil production and accounted for half of oil discoveries in the last 20 years. For example, the discovery of the Tupi field off the coast of Brazil in 2007 was the biggest discovery in the last 20 years worldwide. In the case of China, much of the increase in oil output in the next five years will come from the South China Sea, which is considered to be an under-explored rich hydrocarbon province, according to OPEC World Energy Report Page 10 of 25

11 Exhibit 11: Deepwater CAPEX Rising demand for offshore rig equipment. According to The World Deepwater Market Report by Douglas Westwood, deepwater expenditure in will be 36% higher than the preceding five year period. Of these, 24%, or US$8.4bn will go to rigs in These capex will be spent on new rigs as well as on upgrading aging rigs. According to Rigzone, of all the 660 offshore rigs in the world in August 2007, 546, or 83%, were more than 19 years old. There is pent up demand for revamping these aging rigs to improve efficiency and safety. Given the US$8.4bn market size, and TSC s FY08 revenue of only US$160m, there is significant room for growth. Forecast CAPEX in deepwater Deepwater CAPEX by components Estimated deepwater market size Drilling and completion of development wells 33% Others 7% Platforms 24% US$ Billion Pipelines 36% TSC's sales in 2008 Potental global market size in 2013 Source: Company; Douglas Westwood Exhibit 12: Aging Rig Fleet Rig Type* No. of Aged Rig Age Jackup yrs Semisubmersible yrs Drillship yrs Number of aged rigs 546 Approximate total number of offshore rigs 660 % of Rigs 19+yrs old 83% Source: Company; Rigzone (as of 9 August 2008) * Note: Jackups are generally used in relatively shallow waters (generally less than 120m deep), where they stand on the sea floor, supported by a number of supporting legs; Semi-submersibles are floating structure that can be used in water depths from 60 to 3,050m, while drillships are able to drill in water depths up to 3,660m. (Source: Wikipedia) Page 11 of 25

12 Total solution is the way forward. The offshore rig equipment market used to be populated by a large number of vendors providing separate pieces of equipment. However, integration of different equipment interfaces and matching the delivery schedules of the many vendors caused headaches. As such, purchasing from a total solution provider like TSC could save significant integration cost and delivery time for the customers. Competition. US-based National Oilwell was the first to recognize the need for total solution. Accordingly, it carried out a series of M&A to consolidate the market and ultimately became a total solution provider when it merged with Varco in The combined entity National Oilwell Varco ( NOV ) wielded considerable market clout during 2005 and In 2008, NOV reported US$1.95bn in net profit with revenue of US$13.4bn. According to Spears & Associates, NOV has approximately 60% share of the rig equipment market. TSC management estimates that NOV has more than 70% of the total solution market, while Norway-based Aker Solutions ( Aker ) has more than 20%. Aker is an engineering and construction conglomerate with US$10.1bn revenue in Its Products & Technologies division, which includes deepwater drilling, contributed US$2.5bn in revenue in Customers. Customers for rig equipments include international and national oil and gas companies such as Exxon Mobile, ConocoPhillips, Petrobras, CNOOC, Sinopec, as well as drilling contractors such as Transocean. Quality comes first. Product quality is the top consideration of customers because of: 1) the difficulty of working in the geologically complex offshore environment; 2) the day rates of offshore rigs (US$60k-600k) are much higher than those of onshore rigs (US$8k-35k), delays due to equipment failures are very costly. That is why it d be difficult for a company with no track record to compete against incumbents by simply offering self-claimed quality products at lower prices. That is also why acquiring existing brand names and technologies with proven record is a core strategy adopted by TSC. Price is also important. Rigs are expensive to build. A jackup costs about US$ m, a semisubmersible costs about US$ m, while a drillship may cost up to US$ m. Given such big price tags, even minor savings could be significant in absolute monetary terms. Time is money. Given the aforementioned day rates of offshore rigs, a shorter delivery time could mean significant revenue or savings for customers. Assuming a day rate of US$160k (based on Rigzone data for a Jackup IC WD, 30 Dec 2009), shortening delivery time by 2 months will translate into additional revenue or rent savings of US$9.6m for customers, equivalent to lowering a rig s cost by an additional 5-6%. Value chain. Rig construction starts with an overall rig design by a design company. Then equipment makers carry out concept design, detail design and manufacturing of individual equipments. Lastly, shipbuilders integrate the equipments with the platform and structural steelworks for rig completion. Page 12 of 25

13 TSC s Strategy Attractive value proposition for customers. For customers, TSC stands as a provider of globally competitive rig equipments, conveniently packaged into a total solution to reduce integration problems, at 10-25% lower price and 10-15% shorter delivery time. Equally important is that TSC serves as an alternative for customers to counter the duopoly of NOV and Aker. A total solution provider. According to management, TSC can provide 75% of all rig equipments in-house, enabling it to claim itself as a total solution provider. As explained in the Industry Analysis section, purchasing from a total solution provider like TSC could save significant integration cost and delivery time for the customers. As such, TSC has a competitive edge against individual equipment makers. Offering globally competitive products through M&A. As explained in Industry Analysis, quality is the number 1 factor when customers evaluate equipment makers. Yet quality needs evidence while record provides the best evidence. That is why, in the last few years, TSC s management focused on assembling a comprehensive range of globally competitive products by acquiring existing brand names and technologies with proven records. Actually, this is the same strategy adopted by NOV during its rise. Important GME acquisition. Among its acquisitions, that of the AIM-listed GME in July 2008 for US$23m (approx. HK$204m) was of particular importance: Complementary products - GME s strength is in the design and production of specialized mechanical handling equipments. These mechanical handling products complemented TSC s existing drilling products, thus completing the transformation of TSC from an individual equipment maker to a total solution provider. Proven record - By acquiring GME, TSC not only obtained valuable intellectual properties, experienced staff and global sales and service network, but also an important intangible asset more than 25 years proven record and presence in 23% of the world s semisubmersible rigs. Although GME (now renamed TSCUK) was in a loss-making position before the acquisition, TSC s management is confident of turning around the business by shifting the labor intensive detail designing and assembly processes to China. Given that TSC used to be the agent of GME in China with good knowledge about the company and its products, we are positive about the prospects of the turnaround. Page 13 of 25

14 Competitive pricing supported by low cost production in China. The prices of TSC s total solution packages and individual equipments are 10-15% and 20-25% below that of its competitors respectively. This is supported by the low cost advantage derived from its production base in China: Lower cost of detail engineering Detail engineering refers to the process of turning concept designs into detailed engineering plans for production. It is a very labor intensive process as it involves a lot of detail works by engineers. At present, TSCUK (formerly known as GME) conducts both concept design and detail engineering in the developed countries where the wage level of engineers is high. Management said that they intend to keep the more sophisticated concept design works overseas, but shift detail engineering works to China. Given the large number of engineering graduates in China, management said that the wage of a qualified detail engineer in China is about RMB5,000/mth (~US$9,000/yr) while that of a US engineer is about US$50,000/yr, i.e. a Chinese engineer s pay is less than 20% of a US counterpart. Lower cost of manufacturing Manufacturing costs are general lower in China because of lower cost of labor, land, raw materials and overheads The production plants of NOV are mostly based in the developed countries, especially the US. Although it has a JV plant in China, the JV produces mostly low value-added products. According to TSC management, as the Chinese government is limiting foreign ownership of sensitive equipment industries to a maximum of 75%, NOV is unlikely to move its production base to China. As such, we think TSC s cost advantage is sustainable. Exhibit 13: TSC s Production and R&D Base in China Zhengzhou Zhengzhou Gear Highlight Located in High-Tech Industries Development Zone, Zhengzhou with GFA: 7,500 sq.m R&D, manufacturing and sale of equipment for offshore drilling and gear boxes for jacking systems Manufactures various HHTC offshore and onshore solids control products Located at Xian with GFA: 11,566 sq.m Manufactures SCR and VFD systems, electronic driller and Control systems Xian Located in Zhengzhou High-Tech Industries Development Zone with GFA: 18,000sq.m Manufacturing various offshore and onshore solid control products Qingdao Zhengzhou Dalian Longkou Dalian GFA: 15,000 sq.m Manufacture rig equipment such as mud pumps, drawworks, rotary tables, skidding systems, CTUs, BOP handling systems Longkou Site area: 46.7 hectares Production base for rig total solution packages Qingdao R&D Qingdao TSC Offshore Equipment Manufactures offshore rig equipment such as mud pumps, drawworks, rotary tables Qingdao Manufacture Site area: 10,800 sq.m Manufactures rig consumables such as fluid end expendables including liners, pistons, rods, valves and seats, modules and accessories Source: Company Page 14 of 25

15 Speed advantage. TSC saves 2-3 months or about 10-15% delivery time because of the following reasons: Parallel production enabled by YRS s crane YRS, a strategic shareholder, has the world s largest crane with lifting capacity of 20,000MT. As such, instead of sequential production (i.e. producing platform and structural steelworks first, and then installing the equipments), the production of platform/structural works and equipments could proceed in parallel. The finished equipments can then by lifted onto the structural works by the giant crane. Exhibit 14: YRS s Taisun Crane Source: Company Versatility of Chinese labor This refers to the flexibility of Chinese labor in working overtime to match deadlines. Shorter transportation time to China s shipyards China has become the world s largest ship building country. With its equipment production base in China, the transportation time for TSC equipments to China s shipyard for rig completion is shorter. Strategic vertical alliance. Over the past few years, TSC has, through a series of interlocking equity interests, formed a network of strategic alliance along the rig value chain. These strategic alliance will help it to provide competitive total solution to customers and win orders. The partners include: Friede & Goldman the No. 1 rig designer in the world Yantai Raffles Shipyard the No. 1 rig builder in China and the No.3 semisubmersible builder in the world. CIMC - 1 of the 8 companies with approval from the Chinese government to enter the offshore industry. TSC s strategic alliance and shareholding structures along the value chain are shown in the following Exhibit: Page 15 of 25

16 Oriental Patron Research - Equities TSC s Vertical Alliance TSC, has through a series of interlocking equity interests, formed a solid alliance with leading players along the rig value chain. These strategic alliance will help it to provide competitive total solution to customers and win orders. Exhibit 15: Rig Value Chain & TSC s Strategic Shareholding Structure Value Chain Shareholding Structure UPSTREAM Rig Design 25% Friede & Goldman * No. 1 rig designer globally Executive Chairman Mr. Jiang Binghua CEO Mr. Zhang Menggui 50% 50% I.I. H.C Industrial Investment Global Energy Investors Keywise Capital Mgt (HK) DnB Nor Asset Mgt Public Shareholders 5% 21% 5% 6% 38% MIDSTREAM Rig Equipment 28% * 1 of 3 rig total solution provider globally TSC Offshore (206.HK) 8% Sharp Vision 10% 7% Mr. Brian Chang 100% DOWNSTREAM Shipyard * No. 1 rig builder in China No. 3 semisubmersible builder globally Yantai Raffles Shipyard (YRSL.NO) 34% General Offer (16 Nov 2009) CIMC ( SZ) * 1 of 8 being granted government approval to enter offshore industry Source: OP Research; Company Page 16 of 25

17 Other Favorable Factors Strong growth potential in China s offshore rig market. China s offshore oil and gas resources are underdeveloped. According to Rigzone, the total number of rigs of all Chinese companies is only a meager 38, whereas one US company Transocean, the leading drilling contractor, alone has 151 rigs. To encourage the development of offshore resources, the Chinese government has now allowed PetroChina and Sinopec to enter the offshore market, where CNOOC used to have exclusive rights. According to the Revitalisation Plan for Shipyard and Related Industries approved by the State Council in early 2009, the government intends to develop, among others, offshore engineering and equipment as new economic driving force in China, and strive to expand the market share of the China s offshore engineering in the global market. Exhibit 16: No. of Offhore Rigs: China vs Transocean China (all Chinese companies combined) Transocean (one company) Total offshore rigs Deepwater rigs 1 (under construction) 151 Source: Rigzone Government policy supports. According to the Ministry of Industry and Information technology ( MIIT), the government intends to provide a series of favorable policies to support the development of domestic offshore oil engineering: 1) financial supports including favorable tax rates, investment and credit support; 2) technological supports which includes encouraging R&D as well as overseas M&A to acquire state-of-the-art technology; 3) market development supports so as to enlarge China s share of the downstream shipbuilding market and encourage the development of rig equipment by ship builders. As the only domestic total solution provider, we believe TSC will benefit from these supports. Strategic relationship with CIMC. CIMC is one of the eight companies granted approval by the government, with entailing government support, to enter the offshore market with the intention to become a leading offshore rig builder. It currently holds 8% direct interest in TSC. As it has proposed a General Offer for the Oslo-listed YRS on 16 November 2009, its stake in TSC may rise to 15%. It is difficult to foretell how the relationship between CIMC and TSC would evolve. Nevertheless, we could not rule out the possibility of CIMC further raising its stake in TSC, although we believe current management will retain a significant stake. China becoming the world s largest shipbuilding country. According to RNCOS, China has become the largest shipbuilding country in the world, surpassing Korea. It expects China s total order book for shipbuilding to account for nearly 50% global order book by Factors driving the growth include: 1) strong domestic demand 2) low steel cost 3) low labor cost. Steel is the most important raw material in shipbuilding. Chinese shipbuilders benefit from the availability of low cost steel in China, which is the largest steel making company in the world. On the other hand, labor cost account for 10% of shipbuilding cost. The hourly wage rate of a Chinese labor is one-third Page 17 of 25

18 that of Korea. Chinese shipyards are thus very competitive in producing rig platform and steelworks, which account for 50-60% of a rig s total cost. Page 18 of 25

19 Management Co-founders Jiang Binghua and Zhang Menggui, Morgan, are Executive Chairman and CEO of the company respectively. Mr. Jiang has over 35 years industry experience and had worked for domestic oil and gas companies such as Sinopec, CNPC and CNOOC. Mr. Zhang has over 25 years industry experience and had worked for CNPC and Cook Inlet Regions Inc. in Alaska. COO, Bob Silva has about 30 years industry experience in multinational and Chinese oil and equipment companies. To reiterate our point in Investment Highlights, the management of TSC impressed us as a group of people with extensive domestic and international industry experience, with a strong ambition to develop the company into a global leader, and with the ability to execute, as evidenced by the company s rapid growth in the past few years and the piecing together of a clear and sensible strategy. Conclusion: We believe TSC has a winning strategy on hand, i.e. globally competitive product at China price and speed. As such, we believe it is ready to go and grab market shares in the large and growing offshore rig equipment market. For investors who seek to benefit from world s growing need for oil, TSC seems to be good bet with the potential of significant capital gains in the long run, in our opinion. Page 19 of 25

20 Earnings Outlook FY09 likely to be a down year. In 1H09, TSC made a net profit of US$5.9m from total revenue of US$70m, up 55% and 7% yoy respectively. For FY09, we expect its revenue to fall by 22% yoy to US$125m and net profit to fall by 25% yoy to US$8m. As a result of the recent economic downturn, TSC has seen its order book shrunk from US$181m at end of 1H08 to US$115m at end of FY08, and then to US$99m at end of 1H09. We expect the lagging effect of dwindling order book to be reflected in 2H09 results, thus dragging down full year revenue. On the other hand, we expect net margin to stay low at 6.2%, which is slightly lower than FY08 s 6.4%, as the company finish off delivering the low margin orders of former GME. Although TSC has been winning new orders at better margins as the market warms up recently, the positive effects will not be reflected in current year results. FY10 should be a good year. We expect TSC s FY10 revenue and net profit to grow by 48% and 119% yoy respectively: Revenue: We expect the company to obtain sizable orders in FY10, as the market warms up and as customers increasingly recognize the merits of TSC s product offerings. According to management, the company currently has a quotation log with a value of approximately US$2.0bn. This is a significant increase from US$352m at the end of FY08, or US$631m at end of March The company has received quotation enquiries from customers in Korea, Russia, India, Brazil and Vietnam. Management said many enquiries were made by new customers who previously did not even have TSC on their radar screen. Although these quotations will not necessarily turn into real orders, they are a good indicator that TSC s strategy is working. Margin: We expect net margin to rise to 9.2%, as the company starts delivering new orders which have higher margins and benefits from the improvement in operating leverage. The best is yet to come. We believe time is on the side of TSC, as its strategy gathers momentum, both internally and externally. As such, we will not be surprised to see TSC s operating results really taking-off during FY Significant growth potential. Over a five-year horizon, we expect TSC s net profit to grow by 38% CAGR during FY As explained in Investment Highlights, we assume rig capex in 2013 to be US$7.0bn, ~15% below the forecast by Douglas Westwood. If TSC s market share were to increase to 7% in 2013 (a conservative assumption given TSC s sensible strategy), the company s turnover could rise to US$500m. Given its cost advantage and the low degree of competition in the industry, assuming a conservative 10% net margin, TSC s net profit could rise to US$50m in FY13, representing a 5 year CAGR of 38%. Page 20 of 25

21 Oriental Patron Research - Equities Valuation Peer. As a total solution provider for offshore rig equipments, there are no comparable HK-listed peers for TSC. Although Honghua (176.HK) is also a rig equipment maker, it focuses on onshore rigs, which have quite different economics and competitive nature. Globally, the US-listed NOV and Oslo-listed Aker Solutions are comparable peers, as they both provide total solution for offshore rig equipments. NOV and Aker are currently trading at average 14x FY10F PER. However, market consensus indicates weak earning growth for these two companies, whereas we expect TSC to post significant growth in FY10 and FY11. Valuation. In our opinion, the valuation of TSC should reflect its high growth potential but provide allowance for its relatively short history as a total solution provider. As such, we think a discounted PEG is the right valuation approach for TSC. Our target price is HK$4.50, based on approximately 0.50 FY10F PEG or 22x FY10F PER, representing a 60% upside potential. The low target PEG ratio we pick is to allow for TSC s short history. We would consider raising the target PEG ratio when there is better order visibility to confirm TSC s ability to win orders as a total solution provider. Exhibit 17: Peer Group Comparison bloomberg Year Mkt Cap Price 1D 1M YTD PER (x) Yield (%) P/B (x) ROE (%) NP growth (%) EPS growth (%) OP margin (%) code Currency End (mil) 30/12/09 (%) (%) (%) FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E FY09E FY10E TSC Offshore Grp 206 HK HKD 12/2008 1, N/A N/A Natl Oilwell Var NOV US HKD 12/ , Aker Solutions A AKSO NO HKD 12/ , Peer Average , Source: Bloomberg Page 21 of 25

22 Risks Short history as a total solution provider. TSC is a new comer to the total solution market. There is the risk that it may take a very long time for customers to accept TSC as a credible alternative from NOV and Aker. However, as explained before, we believe time is on the side of TSC. Thin product line. TSC is able to offer 75% of all rig equipments in-house. However, for each type of equipment, TSC offers fewer variants / specifications than NOV. Therefore, TSC may not be able to compete against NOV effectively across the board. Recognizing the weakness, TSC plans to use recently raised funds (a total of HK$220m raised in Dec 2009) for developing more deep water rig products and acquisitions. Integration risk. There is the risk that TSC may not successfully integrate the GME business. To secure GME staff loyalty, TSC has offered share options and promotions to key staff. Furthermore, TSC has announced recently that it is getting orders for products of TSCUK (renamed from GME). This is a good sign that the integration is progressing positively. Adverse oil price movement. There is the risk that oil price may fall to levels too low for offshore drilling to be profitable, thus affecting the demand for rig equipments. However, we believe that the insatiable demand for energy by emerging giants like China and India has fundamentally changed the supply and demand equation of oil. As mentioned above, EIA believes that the impacts of current economic downturn on petroleum demand are likely to be short-lived. It also expects national economies and oil to begin recovering in Page 22 of 25

23 Financials Exhibit 18: Income Statement Year ended Dec (USDm) F 2010F 2011F Revenue Cost of sales (20) (114) (85) (124) (173) Gross profit Other income & expense - net 1 (4) (3) (5) (9) Selling and distribution costs (3) (9) (6) (12) (18) Administrative expenses (8) (18) (23) (25) (31) Operating profit Profit/(loss) of associates 1 (2) Finance costs (0) (1) (1) 1 (1) Profit before income tax Income tax expense (0) (2) (2) (4) (7) Net profit Source: Company; OP Research Exhibit 19: Balance Sheet Year ended Dec (USDm) F 2010F 2011F Property, plant and equipment Property under development Interest in leasehold land held for own use under operating leases Goodwill Intangible assets Interest in associates Deferred tax assets Non-current assets Inventories Trade receivables Others Pledged bank deposits Cash and cash equivalents Current assets Trade payables Bank borrowings Others Current liabilities Bank borrowings Others Non-current liabilities Net assets Source: Company; OP Research Page 23 of 25

24 Exhibit 20: Cashflow Statement Year ended Dec (USDm) F 2010F 2011F Profit before tax Share of profit of associates (1) 2 (2) (2) (3) Depreciation & Amortization Fiance cost/income - net (0) 0 1 (1) 1 Other adjustments Operating cash flow before change in WC Changes in working capital 7 (52) 2 (31) (8) Cash generated from operations 11 (32) 17 (5) 30 Finance income/(expense) (0) (1) (1) 1 (1) Income tax paid (1) (1) (2) (4) (7) Net cash generated from operating activities 10 (33) 15 (8) 22 CAPEX (4) (12) (10) (12) (22) M&A (11) (15) (2) (3) (6) Others 0 1 (2) 1 1 Net cash used in investing activities (15) (25) (14) (14) (27) Share capital raised Increase/(decrease) in bank borrowing 1 (10) (2) 2 2 Dividend paid Others (0) 2 (1) - 1 Net cash generated from/(used in) financing activities Net increase/(decrease) in cash and cash equivalents 40 (29) 27 (20) (2) Source: Company; OP Research Exhibit 21: Key Ratios Year ended Dec (USDm) F 2010F 2011F Growth (%) Revenue (22) EBIT (19) 272 (44) Net profit (8) 163 (25) EPS (35) 93 (46) Profitability (%) Gross margin Net margin ROA ROE Leverage (%) Total liabilities / assets Total liabilities / equity Net debt (cash) / equity (53) (5) (23) (7) (4) Working capital Current ratio Days of inventory Days of trade receivables Days of trade payables Source: Company; OP Research Page 24 of 25

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