Initial Report: Sembcorp Industries Ltd (U96.SI), 304% 5-yr Potential Upside (EIP, Girvin CHANG)

Girvin believes that Sembcorp is undervalued and incorporates ESG analysis in his valuation of the company. Let's take a look at his thesis - do you agree?

LinkedIn | Girvin CHANG

Company overview

Sembcorp is one of Singapore’s largest conglomerates and leading providers of renewable energy. Sembcorp also operates numerous government-led industrial park development projects in Vietnam and China. Additionally, their utility business that comprises gas, power generation and water processing has expanded rapidly thanks to efforts by the current Group President and CEO Tang Kin Fei. SembCorp underwent a re-organization of its businesses in 2021, aligning with its strategic plan to transition their portfolio from brown to green. Previously, the company had three reportable segments: Energy, Urban, and Other Businesses and Corporate. The re-organization resulted in four reportable segments: Renewables, Integrated Urban Solutions, Conventional Energy, and Other Businesses and Corporate.

According to Sembcorp's 2022 Annual Report, the Conventional Energy segment contributed the largest share of revenue ($6,574 million), followed by Integrated Urban Solutions ($444 million), Renewables ($506 million), and Other Businesses and Corporate ($328 million). Overall, all revenue segments experienced improvements from 2021 to 2022. This positive performance led to a net profit of S$848 million in 2022, a significant increase compared to the net profit of S$279 million in 2021. In 2020, Sembcorp recorded a net loss of S$997 million, primarily due to losses on discontinued operations, including a net loss of S$184 million from the Marine business.

Sembcorp operates in six principal geographical segments. In terms of revenue, Singapore customers accounted for the largest share at 75.2%, followed by the United Kingdom (UK) at 13.4% and India at 4.45%. However, the distribution of total assets differs, with 33.8% of Sembcorp's assets located in India, followed by China at 25.1% and Singapore at 20.9%.

Revenue drivers

The key driver identified are as follows:

Renewables: Sembcorp pride itself as the leading Asian renewable energy player leveraging solar and wind resources to generate electricity, offering energy storage solutions, facilitating the trading of EACs, and providing system services to support the integration of renewables into the grid. It boasts one of Asia’s largest energy storage system (ESS) operators and dominant renewables player in Singapore with a full spectrum of solar capabilities such as rooftop, ground-mounted and floating solar projects. Its presence in both India and China has grown from strength to strength over the year. Furthermore, the demand for ESS is expected to grow for both Vietnam and the UK, translating to revenue growth for the renewables segment.

Integrated Urban Solutions: This segment supports sustainable development through its suite of urban, water as well as waste and waste-to-resource solutions. For example, the development of large-scale integrated urban developments and integrated, production and reclamation of water and industrial wastewater treatment as well as solid waste management and waste-to-resource solutions. This segment also includes decarbonisation solutions like carbon capture, utilisation and storage (CCUS) projects.

Figure 1 An investment license was granted in 2023 for the development of VSIP Nghe An (park II), a 500ha expansion over park

Recent key developments includes SembCorp being awarded investment licenses to develop industrial parks in Quang Tri Industrial Park, Vietnam Singapore Industrial Park (VSIP) Binh Duong III, VSIP Can Tho and VSIP Nghe An (park II) in Vietnam and the groundbreaking of VSIP Binh Duong III, a new smart and sustainable industrial park. The initial phase of 100 hectares has received pre-qualification to meet Singapore's Building and Construction Authority's Green Mark for industrial districts, establishing it as one of Vietnam's most environmentally friendly and sustainable workplace environments. The central government of Vietnam also announced a master plan for the region, with a vision towards making Can Tho City a centre for trade and services by 2030. Can Tho City has the potential to build on its established aquaculture and agriculture industries and further strengthen its position as a prominent hub for mega food-processing and distribution, with infrastructure investments being planned under the new master plan. Therefore, this may accelerate projects for the Integrated Urban Solutions segment.

Conventional Energy: The Conventional Energy portfolio is still SembCorp’s largest revenue segment at around 83%. Its principal activities include the sale of energy molecules (including natural gas, steam and electricity from a diversity of fossil fuels such as natural gas and coal) and water products from its integrated assets (Annual Report, 2023). The strong performance in 2022 is attributed to gas, coal and electricity prices rising to their highest levels in decades amidst greater energy demand, coupled with supply constraints as a result of ongoing geopolitical tensions. For example, its operations in Singapore and the UK performed better due to higher power prices and margins, partially offset by higher expected credit loss (ECL) provisions for the service concession receivables of Sembcorp Myingyan Power Company (SMPC).

As Sembcorp operates in multiple countries mentioned above, this is a form of revenue diversification across different markets. The company's strong presence in Singapore, the UK and India positions it to leverage opportunities and capture revenue from these regions. That being said, the revenue contribution and growth in specific geographical segments would be highly dependent on factors such as market demand, regulatory environments, and economic conditions.

Cost driver(s)

According to Sembcorp's 2022 Annual Report, the cost of sales forms the bulk (84.3%) of revenue. They include costs arising from Fuel and Energy, Maintenance and Operations, Manpower, Maintenance and Operations and Regulatory Compliance. There is no additional information (notes to financial statement) with respect to cost of sales in the annual report. Hence, it is assumed to follows a largely linear relationship with the trajectory of projected revenue.

ESG considerations

Sembcorp considers ESG factors as integral to its business strategy. This is evident when it announced its strategic plan to transform its portfolio from brown to green through a series of goals including its commitment to the Sustainable Development Goals in 2021 (Sembcorp, 2021). Sembcorp strives to integrate sustainability into its operations, mitigate environmental impacts, create positive social outcomes, and maintain strong governance practices. By doing so, Sembcorp aims to contribute to a more sustainable and responsible future. As much as its portfolio still consists of a substantial weightage in conventional energy, this reflets SembCorp’s awareness and its intention to transit brown to green.

Figure 2. Sembcorp’s Commitment to Sustainable Development Goals

In terms of board composition, Sembcorp disclosed that the board has implemented a board diversity policy. However, information deriving from the annual report reflected the existing board consists of one female director and nine male directors. Further, the board’s average age is 62 years old, with only two board members who are below 60 years of age.

Economic moats

Sembcorp has invaluable intangible assets in the form of its brand reputation and technical expertise in Sustainable Solutions. Sembcorp's reputation as a trusted provider of energy and utilities services contributes to its economic moat. Its long-standing presence in the market and track record of delivering reliable and high-quality solutions enhance customer loyalty, rendering it challenging for its competitors to shave its market share.

Furthermore, Sembcorp's strategic focus on transitioning its portfolio from brown to green positions the company as a leader in providing sustainable solutions. Its experience and capabilities in renewable energy, water management, and environmental services positions Sembcorp as a preferred partner for customers seeking cutting-edge solutions in meeting the growing demand for environmentally friendly solutions. This again makes it difficult for its competitors to win over Sembcorp’s’ existing clients.

Investment thesis

Firstly, Sembcorp’s commitment in transitioning clearly aligns with the Singapore’s national climate target to achieve “net zero emissions by 2050” as part of her Long-Term Low-Emissions development Strategy (LEDS). The joint statement announced by the National Climate Change Secretariat (NCCS) and the Ministry of Sustainability and the Environment (MSE) highlighted that these targets are contingent upon the technological advances and the economic viability of low-carbon technologies such as hydrogen and CCUS (NCCS, 2022), an area Sembcorp its actively pursuing. This poses as a good hedge against sector-specific risks such as taxation.

Next, the revised 2030 Nationally Determined Contribution (NDC) are also heavily dependent on the status of Singapore’s renewable energy imports. Beyond Singapore, the energy demand is expected to see an uplift especially in the regions of China and India. This is due to factors such as China’s reopening and the surge in the development of “China+” manufacturing bases in India as global manufacturers seeks to diversify their risks (Ho, 2023). Considering that Sembcorp is actively progressing in the operations of renewables, this is a significant tailwind for Sembcorp.

Finally, Sembcorp has a strong balance sheet and financials, allowing it to tide through crises through its sheer financial stability and resilience. Apart from a strong asset base comprising healthy levels of tangible and intangible assets, Sembcorp also ensures its liquidity is sufficient with cash and cash equivalents worth beyond $1 billion (Annual Report, 2022). Consistently having a strong asset base and healthy cash balances would ensure that Sembcorp is less affected by short-term headwinds and market fluctuations.

Valuation

Sembcorp’s has four revenue segments, namely Renewables, Integrated Urban Solutions, Conventional Energy, and Other Businesses and Corporate. In total, revenue and other operating income (net) is projected to grow by around 15% year-on-year for the next two years and then taper down to around 10%. This is due to 2022 having an exceptionally high growth stemming from its Conventional Energy segment, which is unlikely to be a suitable growth rate especially with Sembcorp’s transition strategy. This is also in consideration with the positive developments from the respective revenue segments mentioned earlier in this write-up, barring the Conventional Energy segment. Cost of sales is assumed to move in relation to revenue. The other line items are projected as a moving average of prior year data.

The free cash flow to the firm (FCFF) for the next five years would then be discounted to the present value. The weighted average cost of capital (WACC) of 7% is rounded up from the 6.9% retrieved from secondary research (Source). The present value of the sum of FCFFs is projected to be $3,965 million. Terminal growth rate of 3% is used to calculate the terminal value at FY2027 to be $909.1 million. The present value of the terminal value as of FY2027 is therefore calculated to be $23,408million. Finally. By summing up the present values of the FCFF and terminal value, the enterprise value is projected to be $20,655 million. With the number of shares as of valuation date to be 1,780 million, the share price of Sembcorp would be $11.60, $12.23 and $13.66 for FY2022, FY2025 and FY2027 respectively.

Risks and mitigation

Conventional energy portfolio: Despite its commitment towards renewables, the Conventional Energy segment still contributed the largest share of revenue currently and is therefore susceptible to wholesale electricity price movements. This is evident in 2022 where gas, coal and electricity prices rose to their highest levels in decades due to a combination of higher energy demand with supply constraints as a result of ongoing geopolitical tensions. Such performances are macro-driven which means it is unlikely to persist in the long-term, admit the growing awareness on energy conservation and the stabilisation of energy supply. The key mitigating factor would be for Sembcorp to remain steadfast in tis transition strategy.

Board competency: The board plays an integral role in steering Sembcorp towards its loft transition goals. Therefore, a key risk would materialise if the board does not have the competency in the field of transitioning. Based on the annual report, the board does not have a Chief Sustainability Officer (CSO). That being said, Sembcorp has a Sustainability Steering Committee that provides strategic direction for managing sustainability related risks and opportunities. The committee is spearheaded by Sembcorp's Chief Financial Officer and comprises senior executives who are primarily accountable for the management of Sembcorp’s material sustainability issues.

ESG assessment

Greenwashing risk

On 6 November 2022, Anthropocene Fixed Income Institute (AFII), a non-profit climate finance-focused organization, released a report announcing that Sembcorp should continue accounting for the carbon emissions by following the sale of Sembcorp Energy India Limited (SEIL). SEIL operates two coal-fired plants in India that generates 2.6 Gigawatt (GW) of power. The assertion was due to Sembcorp’s commitment to finance the purchaser, Tanweer Infrastructure (Tanweer) with the full sale amount, resulting in a move akin to shifting operation emissions into financed emission (Erlandsson & Rimaud, 2022). This could be considered as greenwashing if it does not amount to significant real emission cutbacks (Anthropocene Fixed Income Institute, nd).

Board diversity

Referring to previous analysis in the “ESG Consideration” section, though Sembcorp disclosed that it has “in place a Board Diversity Policy which sets out principles to maintain diversity on board composition”, there is a lack of gender diversity within the board with only one in ten of the board members is a female. In addition, the average age of the board is 62 years, indicating that the the board may lack innovative solutions when it comes to supporting Sembcorp’s portfolio transition.

Conclusion

Sembcorp share price is undervalued in comparison with its valuation of $11.60. In the medium to long-term, it possesses a strong reputation and enjoys high switching costs. Though the company faces potential risks such as greenwashing risks and lack of board diversity, it is well on track to reap its benefits provided it commits to its transition strategy in achieving a diversified portfolio.

*Do note that all of this is for information only and should not be taken as investment advice. If you should choose to invest in any of the stocks, you do so at your own risk.