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Are There Any Reasons For Investors To Be Optimistic Over Keppel Corporation Limited?

Keppel Corporation Limited (SGX: BN4) is a well-known blue chip stock in Singapore. But, it has likely become a nightmare for many of its investors over the past few years.

The company’s shares have fallen by nearly half from a peak of around S$12.00 in early 2011 to S$6.75 today. In the process, nearly S$9 billion in market capitalisation had been wiped out. This has happened even as the Straits Times Index (SGX: ^STI), Singapore’s market barometer of which Keppel Corp’s one of the 30 constituents, had lost ‘only’ 10% or so over the same period.

The business

Keppel Corp has two main revenue drivers: The design and building of rigs, and the development of residential and commercial real estate.

The former is facing challenging times ahead with the collapse in the price of oil from more than US$100 per barrel in mid-2014 to less than US$50 today.

The property business is also facing an uphill battle with a tepid residential real estate market in both Singapore and China.

Beyond the less-than-favourable industry dynamics, Keppel Corp is also a company that has not been able to produce positive free cash flow (operating cash flow minus capital expenditures) in all but one year (2012) since 2010. Meanwhile, Keppel Corp’s level of borrowings has also increased markedly with a net-cash position of S$92 million at end-2010 becoming a net-debt position of S$1.71 billion at end-2014.

As you’ve seen, there are a number of negative issues plaguing Keppel Corp at the moment. So, should investors be optimistic about the future of Keppel Corp’s business?

I may be biased since I am a shareholder, but I actually think that things are not as bad as they might seem on the surface.

A positive terrible industry outlook

The industry-wide outlook for Keppel Corp’s major business arms are indeed not bright at all.

The oil & gas industry is starting to see a sharp slowdown after many major oil exploration companies (Keppel Corp’s customers) had decided to cut their capital expenditure budgets for the next few years. This will directly impact Keppel Corp’s marine engineering business segment as it ultimately has to depend on its customers’ capital expenditure budgets.

Cooling measures for the property sector in Singapore and China have also given the market in both countries a weak outlook. As if these weren’t bad enough, Keppel Corp also has to contend with a slowdown in growth for China’s economy.

But here’s the thing, the best times to invest can come when the business environment looks the bleakest. That’s why the legendary investor, Sir John Templeton, has these words: “The time of maximum pessimism is the best to buy, and the time of maximum optimism is the best time to sell.”

Both the oil & gas and real estate sectors are cyclical in nature. There is no reason to believe that the world will not have a need for oil in the future nor is there any basis to think that people will no longer require places to live and work in the future. And since both industries are cyclical in nature, shouldn’t we be greedy now that others are fearful? (Remember Templeton’s words?)

A good thing here with negative free cash flow and climbing debt

You can get a better picture of Keppel Corp’s dismal track record in producing free cash flow since 2010 in the table below:

Year Keppel Corp’s free cash flow
2010 -S$422.8 million
2011 -S$1.01 billion
2012 S$170.6 million
2013 -S$299.3 million
2014 -S$590.2 million

Source: S&P Capital IQ

And as I already mentioned, the level of borrowings for Keppel Corp has climbed significantly over the same period. It’s usually alarming to see a company having trouble generating free cash flow and borrowing more money at the same time. But, it can also be a positive.

If we look back further in time at Keppel Corp’s history, it was producing healthy amounts of free cash flow prior to the Global Financial Crisis of 2008-09. In fact, the last time the company had generated negative free cash flow was in 2000 and 2001; that was during the collapse of the dotcom bubble and just a few short years after the Asian Financial Crisis had happened.

From the vantage point of both an investor and businessman, I would also increase my investments during or just after a crisis as that would be a nice time to snap up bargains. But if a company were to increase its investments significantly, it may then cause its free cash flow to worsen temporarily.

After-crises periods also tend to be times when interest rates are low as governments would want to keep borrowings costs affordable in order to stimulate the economy. In such a scenario, wouldn’t such times be a great occasion for a company to increase its leverage to lock in low interest rates and gain the capital to invest?

So while persistent negative free cash flow and rising debt levels are things investors wouldn’t normally want to see, both can make sense in certain circumstances. This is where I think the actions of Keppel Corp’s management since 2010 actually does make sense – the Global Financial Crisis resulted in lots of bargains appearing and interest rates were also kept really low.

Foolish Summary

I’m not saying that things won’t get worse for Keppel Corp even at this point or even that the company’s management is doing all the right things. There’s always the chance that management’s acumen is wrong this time around.

But, I do feel that if the market’s running away from Keppel Corp because of its rising debt, negative free cash flow, and the cyclical downturns in the property and oil & gas sector, then I’m quite happy being a long-term contrarian in this instance.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim owns Keppel Corporation.