Sky China @ 50.5 cts ( Oil services / China ) 3 comments
Final Poll Results: 4:5
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1.Operating model suggests potential difficulties in estimating remaining reserves and possibility of overestimation....
2.... as well as consistently high capex
Now this has been a hot stock since the start of 2006 as it is at the confluence of two in-vogue themes: oil and China, but its current valuations look rather stretched given its lack of a post-listing track record and its rather dodgy business model.
Sky China specialises in operating marginal and geographically challenging oilfields, and some might see this as a niche and hence excuse its rather small revenue base of ~S$20M. Here I quote an insight from a forummer (appropriately nicknamed Oil) from the CNA (Channelnewsasia) forum with experience in the oil industry: "being a marginal oilfield operator, they must approach oil companies that own leases or operate the leases. They are supposed to then operate low production, low margin fields with payment based on increased production....... No company will turnover their "cherry" fields. They would only turnover operations to marginal fields. This means low probability of success." Sounds logical, and I think he's dead right in spotting the problem with this model.
There are two key risks, both related to the above. Firstly, the company must depend on their customer's estimates of the remaining oil resources in the marginal fields which they are being asked to take over --- notwithstanding that the company would surely make its own investigations (which must be rather superficial given they don't own the fields), surely it leads to the possibility that they might end up with less oil than originally projected? Obviously the customer would tend to overestimate rather than underestimate, to entice the company to invest and drill. This adds another level of opaqueness to future profit projections, on top of the fact that Sky China hardly has any post-listing track record to boast. And to exacerbate the situation, the company does business with only two main oilfields, both of which are under one parent: Petrochina, a subsidiary of state giant CNPC. The disparity in corporate status and the customer concentration must tilt the balance negatively for Sky China in any contract negotiations.
Secondly, the fact that they specialise in difficult oilfields that even the state-linked companies find uneconomical to drill means two things: they have to keep in constant touch with technology (note their acquisition of patent and technology rights etc) and that they have to make heavy investments in capital equipment to drill in difficult terrain, especially since remuneration is pegged to volume of oil extracted. This heavy capital expenditure is evidenced by the fact that depreciation forms ~25-35% of their COGS (Cost of Goods Sold) --- anything above 10% COGS is massive for any firm, and this is supposed to be a services company! Their customer is effectively transferring capital investment risk to Sky China, at little cost: they pay Sky China on a per-unit-extracted basis. If one checks the latest cash flow statement for Sky China, their operating cashflow has been going into capital investments for FY04 and FY05. In FY04 the deficit was financed by a convertible loan, in FY05 the company obtained new cash proceeds via its IPO. A share placement is very likely coming up while the stock price boom still exists.
It is not that I think this company is no good. They have experienced management who have been able to make the business model work despite what I see as an uphill battle, and their independent director board is excellent: a HSBC securities director and a ComfortDelgro chairman, no less. However, it is now trading at a rather aggressive 14X PE, and has appreciated ~80% from its 28 cents IPO price. People have recognised the China and oil theme in this company, hence pushing up its price, while ignoring things like customer concentration risk, and that they are not likely to receive any dividends from this company in the near future. In short, they are pricing this like a growth stock, when its niche is really not that defensible: WTO liberalisation is going to lead to an influx of foreign players whose technology the Chinese government would be keen to facilitate transfer and exploitation. That might just negate any technological competitive advantages Sky China might possess.