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In my last article, I received a comment to share insight about the possible merger of Keppel Corp (KC) and Sembcorp Marine (SCM) to ensure survival in the light of the current low oil price environment. In response, I wrote this article. To avoid confusion, Keppel Corp is the parent company of Keppel Offshore and Marine (KOM), so the merger on the cards is between KOM and SCM.
WHY A MERGER IS POSSIBLE
Since the oil crisis began in late 2014, both KOM and SCM had been reporting profit slumps. During the heyday, KOM’s earnings attributed to >50% of group’s profits. Today it is a completely different story. While KOM’s revenue is still 25-30% of the Keppel group’s topline, earnings fell drastically. For FY2019, Keppel group earnings is $707m while KOM net profit is S$10m, attributing to a mere 1.5% of what the group earns.
SCM fares worse financially. SCM reported revenue decline in 2019 to S$2.9B from 4.9B a year earlier. Losses widened to S$137m compared to S$74m in 2018. While a big part of the losses is due to impairments, the cost of sales exceeds revenue. This shows that SCM’s projects are loss making, a clear indication that contracts were taken at very low or no margins. Cash is also quickly depleting from S$840m end 2018 to S$390m end 2019. SCM’s balance sheet has a current ratio of 0.9 and a net debt of S$4.1B, of which 1.5B is borrowed from its parent company Sembcorp Industries (SCI).
Temasek share acquisition of Keppel Corp
Last Oct, Temasek offered to buy control of KC in a S$4.1B deal to increase stake from 20.5% to 51%. The offered price is S$7.35. The deal will likely to be concluded this year subject to domestic and foreign regulator’s approval. In the deal, Temasek publicly stated that it does not intend to delist KC, and it will undertake strategic review of its business with the objective of creating a sustainable value of all shareholders. The strategic review does not discount possibility of a merger. See below quote.
QUOTE : “ The Offeror remains open to all possibilities arising from the Strategic Review. The Strategic Review may result in (i) the Company refocusing on and strengthening certain businesses, and/or (ii) potential corporate actions including, but not limited to, joint ventures, strategic partnerships, acquisitions, disposals, mergers, or other transactions involving the Company, in each case as determined by the board of directors of the Company in the best interests of the Company and Shareholders.” UNQUOTE
Temasek is also 50% owner of SCI which in turn owns 61% of SCM. With the acquisition of additional Keppel shares, one does not rule out possibility that Temasek will then sell off KOM to merge into SCM.
Benefits of merger
Both KOM and SCM offer rig and shipbuilding, ship conversion and ship repair services. While KOM and SCM employ different strategies and business focus, there is significant overlap of expertise. Human capital and yard facilities can easily be crossed-use to achieve higher efficiency and capacity utilization. Merger can increase global market share and reduce competition to achieve better contract pricing. After-all, KOM and SCM are the world’s first and second biggest builders of oil rigs respectively. Supply chain pricing power will also improve due to economies of scale. In view of Singapore tightening of foreign employees, a single entity will also solve issues of labor crunch.
Specifically, a merged entity also allows for a more diversified track records of capabilities and experiences. For example, Keppel is specialist for Floating Production Unit (FPU) conversion, but has neither newbuilt track record, nor EPCI Turnkey FPUs experience. On the contrary SCM has received several turnkey EPCI FPU contracts in recent years such as Shell Vito & Whale, Equinor Johan Castberg, Total-Modec Alisa that elevates them to compete with the likes of big shipbuilders in Korea for complex O&G projects. Keppel has recently included delivery of Dredging ships in their portfolio, which SCM has no experience. On the other hand, SCM has more focus in Navy, Ferry, Ro-pax, Cruise-liner repairs, while Keppel has lesser focus in ship repair.
WHY A MERGER IS NOT POSSIBLE
In March 2019, Hyundai Heavy Industries (HHI) signed an estimated U$1.7B agreement with the state-run Korea Development Bank to buy its smaller rival Daewoo Shipbuilding & Marine Engineering (DSME). Following the deal, HHI and DSME will have a combined backlog in very large crude carriers (VLCCs) and LNG carriers accounting for more than 60 percent of the world total.
Due to the monopolistic status, the deal will need to get approval from fair trade authorities in European Union (EU), Japan, China, Singapore and Kazakhstan since these countries have shipping companies which are HHI and DSME’s biggest customers. One year has passed, the merger plan is still under review by the authorities in five countries. So far, only Kazakhstan has approved it.
Earlier in 2018, Japan had already lodged a complaint with the World trade Organization (WTO), claiming that Korean government has provide unfair financial support to Korean shipbuilders. South Korean and Japan held talks on the merger on 30 March 2020 but failed to iron out their differences.
Singapore regulators also said the deal between HHI and DSME threatens to remove competition in the supply of LNG carriers, container ships and oil tankers to Singapore customers. In turn, it will also create high barriers to entry for new players specifically with regards to LNG carriers.
It was reported last month that EU antitrust regulators have suspended their probe into the merger of the two South Korean firms until further notice, waiting for more information to be provided by the companies. Early last year, EU also rejected the transport rail services merger between two giants Siemens and Alstom citing concerns of competition fairness which may lead to higher prices for the passengers.
In view of the extreme difficulty to get approval from fair trade authorities, a possible merger between KOM and SCM, the world’s two largest rig builders will definitely face the same scrutiny and resistance from anti-trust watchdogs.
Mergers is said to bring performance efficiency over the long term, but this always come at the expense of workers who will be made redundant and obsolete.
After the HHI acquisition of DSME is announced, DMSE workers took to the street with the support of union to block the deal, and prevented HHI from making on-site inspection at the DSME shipyard at Geoje. Unionists in South Korea also brought the case to the EU to reject the merger. Andreas Mundt, president of Germany’s Federal Cartel Office, told Korean reporters in March 2019 that a merger was “not a solution” to overcoming the crisis faced by the companies from a market perspective.
In the light of current Corona pandemic with unemployment rising, to have a merger deal now between KOM and SCM could potentially leads to more layoffs. Imagine employees have been working in the maritime industry all your life with skill-set only applies to this sector, and when they are retrenched, what are the odds of them able to transit to other sectors? A merger with profitability at the back of mind, may results in an abrupt rise of unemployment with insufficient time to reallocate the workers who are made obsolete. Temasek being a sovereign fund, I reckon they will also consider this factor seriously.
Inefficiencies from merger
Due to reduce competition within Singapore. Although there are still shipyards in Singapore such as ST Marine and Kuok’s group Paxocean, there is really little other competition within the country. If there is any state-owned projects within Singapore government to be awarded, there will be no or reduced competition. Non-competition over a longer term may cause decline in human efficiency.
Furthermore, KOM and SCM are in general competitive only in niche and high-end projects nowadays. A workforce that is too comfortable will become lackluster in innovations and efficiency over time. In no time, competition from China and Vietnam will catch up and eliminate any competitive edge that the Singapore company has.
In my opinion, there is an equal chance of merger and staying as two independent companies.
On paper merger brings efficiency and makes sense in current low demand environment. But restructuring two sizeable companies into one to make it more efficient is easier said than done in reality. It is not just the tangible financial and mechanical process that accountants and administrators think of.
There are many intangible considerations such as psychological well-being of employees, cultures and loyalty to the company, good people leaving, and deterioration of team spirit when workers are made obsolete etc. As an insider in the industry, both companies have very diverse culture, and very different strategy and direction. It will be an uphill task to make the merger successful in the shortest time.
If you really want me to make a stand, I do not think the merger makes sense in today’s environment. Announcing a merger does not mean instant solution. It may take months or years for antitrust regulatory to approve. Meanwhile, it will just further deteriorate the already low morale of the workforce in both companies.
In addition, both KOM and SCM are already diversifying into the gas and renewables sector with less reliant on O&G. KOM’s orders for 2019 is >S$2B with gas and renewables accounting for more than 60%. SCM achieved $1.49 billion in new orders, of which $530 million related to greener solutions, including gas and renewable energy projects.