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Is It Wise For Sembcorp Industries Limited To Take Sembcorp Marine Ltd Private?

Yesterday, the Business Times reported that the conglomerate Sembcorp Industries Limited (SGX: U96) may have intentions to take its majority-owned offshore & marine arm, Sembcorp Marine Ltd (SGX: S51), private.

Both companies are listed and as of 6 March 2015, Sembcorp Industries owns 61% of Sembcorp Marine.

The Business Times had quoted an unnamed person as saying that “It’s quite clear that financial support [for Sembcorp Marine] has to come in and a take-private is one of the easier options, but ultimately there needs to be a long-term solution.”

There have been no official announcements from both companies on the matter. So as far as I am concerned, it is purely an unsubstantiated rumour.

But for current and prospective investors of Sembcorp Industries, it may still be a good time to consider if it is wise for the company to privatise Sembcorp Marine. There are many angles to approach the question, but I’d like to touch on just one – and that is from the vantage point of Sembcorp Industries’ balance sheet.

The chart below plots the net-debt (total borrowings minus cash & short-term investments) to equity ratios for Sembcorp Industries since the first-quarter of 2008:

Sembcorp Industries' quarterly net-debt to equity ratio since first-quarter of 2008
Source: S&P Capital IQ; author’s caluclations (click chart for larger image)

What is striking here is how fast Sembcorp Industries’ leverage has grown since 2014. In the third-quarter of 2015, the conglomerate had a net-debt to equity ratio of 55%, the highest it has been over the past eight years. (A negative net-debt to equity ratio would mean that Sembcorp Industries has more cash than debt.)

This is important to note when we consider the resources Sembcorp Industries would require to privatise Sembcorp Marine.

At its closing price of S$1.48 yesterday, Sembcorp Marine had a market capitalisation of S$3.09 billion. Most takeovers will see the acquiring party fork out a premium over the target’s prevailing share price. But, Sembcorp Industries will still require S$1.2 billion (39% of S$3.09 billion) to fully acquire Sembcorp Marine at a price of S$1.48 per share, even if we ignore any premiuim.

That sum is not chump-change when we consider Sembcorp Industries’ cash position (S$1.64 billion in cash & equivalents) and balance sheet strength in the third-quarter of 2015. If a privatisation were to take place, Sembcorp Industries will likely need to take on more debt. This can potentially add more stress to the company’s balance sheet, which is already highly-geared in relation to history.

In Warren Buffett’s 2010 Berkshire Hathaway shareholder’s letter, the billionaire investor had the following words of caution when it comes to the use of debt:

“[A]s we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.”

Sembcorp Industries has many utility assets under its wing, which tend to have stable revenue streams. This can provide a margin of safety for management to use debt wisely. But at the same time, leverage has its risks.

In considering whether it’s wise for Sembcorp Industries to privatise Sembcorp Marine, investors may want to think about the balance sheet risks that the company has to take on to get the takeover done and weigh it against any potential benefits that can come with the deal.

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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 Chong Ser Jing owns shares in Berkshire Hathaway.