Saipem surprised us and the Street on Tuesday with a massive revision to its 2013 earnings guidance. Earnings before interest and taxes in 2013 are now expected to be around EUR 750 million, a 50% drop from 2012 levels of EUR 1.5 billion. For a very well-run company with a nearly unblemished operational track record over the past decade and steadily increasing earnings, the magnitude of the revision is stunning.
Broadly, Saipem’s revisions can be tied to several common factors. First, the oil and gas engineering and construction space has struggled with highly competitive market conditions since 2009 and 2010, which has resulted in low margins for much of the work embedded in Saipem’s current backlog. For example, about 80% of the work Saipem expects to do in 2013 is from existing contracts.
In the past, Saipem has consistently won a smaller set of “blockbuster” projects at much higher margins that has camouflaged the pricing deterioration in the backlog. As a result, delays in awards for these key high-margin “blockbuster” projects have prompted Saipem to revise its outlook. Second, while there are no project overruns to report, the new CEO is being more conservative about margin estimates and the timing of contract awards and project execution, given continued project delays. For example, the industry saw about $100 billion of capital investment sanctioned in 2012 versus the $250 billion the industry expected.
The new guidance is fairly ugly across the board. On a segment level, the onshore E&C segment is expected to see a 80% decline in 2013 EBIT due to reduced activity levels for high-margin work mainly in the Middle East, Nigeria, and Algeria, and delays for awards in Venezuela, Nigeria, and Iraq. For the offshore E&C work, 2013 EBIT is expected to drop 70% from 2012 levels due to reduced activity levels in high-margin work in the Baltic Sea, West Africa, and the Caspian Sea, the decision to take lower-margin work in Brazil to support Saipem’s market entry, and the execution of contracts with a limited high-margin marine component. As a slight offset, the onshore and offshore drilling segment is expected to increase EBIT by 20% in 2013, thanks to recent rig deployments.
There are a number of other concerns that the guidance has raised around long-term margins, dividends, and working capital. The 2013 revisions do not imply Saipem has been structurally overstating its margin performance over the past few years, as there are no massive project overruns to report, but merely the inability to offset lower-priced work with larger and more high-margin work because of difficult market conditions.
Saipem expects that it will able to achieve historical margins over time as the backlog is repriced with better contracts signed in a stronger environment. In the meanwhile, Saipem will likely cut its dividend payout in 2013, as the firm has traditionally paid out a third of its earnings. The company is also dealing with significant working capital outflows (over EUR 1 billion in 2012), as the firm has been forced to invest heavily in upfront work for its projects, but project delays have meant that it hasn’t recovered the cash as quickly as it has in the past. In 2013, Saipem expects to recover perhaps EUR 100 million in cash, with the majority of the working capital recovery pushed out to 2014.
The implication of Saipem’s outlook on the rest of the industry is muted, in our view. We believe Saipem more than its peers has leaned heavily on “blockbuster” wins to drive its performance, as Technip TEC suffered from a series of project overruns within its onshore book of business a few years ago, and subsequently embarked on a multi-year effort to enforce more pricing discipline and diversify its backlog. Subsea 7 SUBC is far smaller than Saipem, and thus doesn’t need quite the same level of “blockbuster” wins to ensure a steady book of business, and it also has a larger portion of its revenue devoted to more day-work contracts.
Finally, Petrofac does rely rather heavily on “blockbuster” wins, particularly as the Middle East is growing more competitive for onshore work, which has been a key source of work for the firm in the past. However, the firm has stepped back from new onshore work in the past year amid industrywide project delays, and its onshore backlog is expected to be around $5 billion at the end of 2012 versus $6.4 billion at the end of 2011. As a result, we think the onshore portion of the business will deliver flat revenue growth and similar levels of profitability in 2013, which is a view that Petrofac’s management team recently indicated was realistic. At this time, we do not plan on changing our fair value estimates for any of the other oil and gas E&Cs we cover.
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