The Risks In A Cyclical Company Such As Sembcorp Marine Ltd

It doesn’t rain but it pours” can be an apt quote to describe the current situation of Sembcorp Marine Ltd (SGX: S51), the marine and offshore engineering arm of SembCorp Industries Limited (SGX: U96).

With oil trading at a multi-year low of close to US$30 per barrel, Sembcorp Marine’s business has been badly affected, with a 77% decline in profit in the third-quarter of 2015. Meanwhile, the company had also recently warned that it expects to make a loss in the fourth-quarter of 2015.

The situation is further worsened by the recent speculation that Sete Brasil, an oil & gas company linked to Brazilian oil major Petrobras, could file for bankruptcy soon. Sete Brasil is a major customer of Sembcorp Marine.

All these have resulted in Sembcorp Marine’s shares plunging from around S$3 a year ago to just S$1.40 currently. If Sembcorp Marine’s share price is measured over a longer time frame, it has fallen by a stunning 80% or so from an all-time high of around S$6.00 that was reached in April 2011.

The developments led me to think about the risks of investing in cyclical and order-book driven companies such as Sembcorp Marine and how investors can manage the risks involved.

The low-down on cyclicals

Unlike the stable nature of the utilities business of its parent company Sembcorp Industries, Sembcorp Marine is a highly cyclical business.

In general, when the cycle is moving in upwards, as a result of steadily climbing oil prices, orders to construct rigs from oil producers will rise, resulting in higher revenue, profit margins, and profits for rig builders. In such situations, the share prices of rig builders are likely to climb as well, to reflect the favourable business conditions.

The down-cycle comes when the price of oil starts falling, which is where we find ourselves at the moment. With a low price of oil, there is lower rig-building demand from oil producers, and thus lower order books and profits for rig-builders.

Managing cycles

There are, in my opinion, two different risks here that we need to consider when investing in cyclical businesses: One is business risk and the other is investment risk.

As passive stock market investors, we have little control over business risk, since it is the job of a company’s management team to manage the business. In fact, when we invest in a business in the stock market, we have effectively accepted to take on business risk.

But, we can manage our investment risk by not overpaying for the shares of a company. So it’s back to the basic investing idea of “price is what you pay and value is what you get.” The key here is valuation.

Keeping in mind the caveat that valuation is a subjective matter and that each of us will have different opinions, there are three areas that I would like to look at, when valuing a company such as Sembcorp Marine.

First, I’d monitor the trend of the company’s order book. A stable and rising order book is a good sign, and any decline would ring an alarm to dig deeper.

Second, I’d use an average profit figure (over the past five years, at least) as well as the company’s average price-to-earnings ratio (PE) over the same period to help value the company. Using an average profit figure help to smooth the volatility in profit caused by the cyclical nature of the business; this combined with an average PE ratio (average profit multipled by average PE) gives a reasonable valuation for the company, in my opinion.

Third, I will monitor the trend of the company’s P/E ratio (current price divided by latest profit), which could indicate the stage of the cycle that the company is operating in. It’s worth noting that cyclical companies usually have high P/E ratios at the trough of their business cycles (low profits appear at the trough, resulting in a high P/E).

Foolish Conclusion

As investors, we have very little control over business risk. Thus, our main hedge is to manage our investment risk, and this may be achieved by not overpaying for an investment.

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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 contributor Lawrence Nga doesn’t own shares in any companies mentioned.