Medserv — Update 26 August 2016

Revenues in H1 fell by 36%, due to a 61% decrease in shore-based logistics activity. The majority of the €16m decline was a very low level of activity in Cyprus, with the Larnaca facility mothballed from the beginning of May. This compared to a very active period in the prior year as ENI Cyprus executed its drilling programme. Malta and Libya also faced revenue declines, in large part due to the price reductions being sought by customers to mitigate costs in the face of the adverse operating environment in oil and gas markets.

While Medserv management worked hard to reduce costs, these factors nevertheless affected gross margins during the period. The operating margins are also being affected by development costs associated with new bid activity, which is an indicator of a strengthening contract pipeline.

Management has now completed the purchase price allocation (PPA) exercise for the METS acquisition, creating €15.8m of fixed intangible assets and goodwill of just €2.2m. The PPA intangibles are amortised over periods of 10 years or fewer. The associated amortisation is a non-cash item, so we adjust our operating profits, profit before tax and earnings to exclude it. We include the charge as an exceptional item in our model.

METS generated €6.5m of revenues in its first four months of consolidation, generating operating profit of €0.93m, a margin of 14%, depressed by performance in Iraq. Demand for OCTG goods and services in Oman continued to grow strongly during the period, with the UAE operations recovering towards the period end and returning to profitability. However, Iraq remained difficult despite a year-on-year increase in oil production, hence management is adjusting the cost base to reflect lower volumes.

Following the acquisition of METS, net debt increased to €47m at the half year, with gross cash standing at €7m reflecting the residual balances of METS when acquired. Working capital saw outflows during the first half, with some significant outstanding receivables. We expect these to have been recovered early in the second half of the year. Therefore, despite the lower profit expectation for the current year, we expect net debt at the year-end to be little changed from previous forecasts.

No dividend was declared at the half year although an interim may still be announced with the Q3 results. Given the shortfall on previous expectations and following the completion of METS, we now feel Medserv may seek to protect capital in the current climate and, as a result, may reduce the current year pay-out ratio temporarily from the 40% level. We therefore have assumed a 25% pay-out level for the total 2016 dividend before reverting to 40% as earnings recover in 2017.

It should be noted that the company is changing the treatment of the income from the photovoltaic farm at the Malta base. As a separate segment in reporting this will now be recognised as revenues rather than other operating income. Our previous estimates have been adjusted to reflect the move.

Somewhat late in the day, the Portuguese government has responded to environmental concerns with respect to offshore drilling some 40km off the Algarve coast. To confirm the drilling licence awarded to ENI for an offshore well, a new environmental audit has been ordered. The result is that drilling of one wildcat well in the Atlantic that had been expected in Q416, and for which ENI was preparing, has been delayed to least into 2017.

The decision defers over €3m of revenues from H216. The three-month drilling programme may commence in H117 but given the uncertainty created, we have removed the drilling revenues and profits from our forecasts. The proposed 90-day drilling programme had been a significant part of current year revenue expectations for Medserv, having created a pop-up base facility using assets transferred from Cyprus. ENI is maintaining payments for the base awaiting further developments.

At the beginning of August Medserv announced the renewal of the support contract for a major IOC operating offshore Libya for a further two years. Linked to the Bahr Essalam gas field development, the contract helps to underpin activity levels in Malta, with a number of contractors supporting the project expected to use Malta for operations.

In addition, Medserv has bid in a renewal tender for an existing customer. Together with current contracts, these developments improve the prospects for revenue development in Malta, which we expect to start recovering in H2 and to step up further in 2017.

Prospects for a revival of activity in Cyprus next year have been enhanced by the extension of ENI’s drilling licence earlier in the year and the one-year renewal of Medserv’s port operation licence at Larnaca, which now runs to the end of August 2017. The latter allows operations to recommence when required, having been mothballed since May. Following talks with the Cypriot authorities, ENI Cyprus indicated in early July that it intends to restart drilling on its existing licences in 2017.

A tender for base support operations for a second oil major to start drilling offshore Cyprus has also been submitted. In addition, the third round of licence bidding for Cypriot blocks has seen significant interest following the recent proximate field discoveries. ENI, Total, Statoil, Exxon Mobil, Qatar Petroleum and Cairn have all expressed interest in the licensing round.

The result of the tender to an IOC for an onshore base in Trinidad & Tobago is expected in the third quarter. If successful, the bid would mark a significant international expansion and provide validation of Medserv’s credentials and model. In turn, this could lead to participation in other international tenders for base support.

Egypt has seen further major offshore gas discoveries in 2016 and, with ENI committed to developing its Zohr field activities, Medserv is actively pursuing opportunities to support its activity. Management expects this to develop further during the second half of the year.

Medserv also indicates in its interim statement that, benefiting from METS’s position in Oman, it has bid to provide shore-based logistics for an offshore exploratory drilling programme in the country.

Trading for the Oman arm of METS has continued to strengthen, and significant growth is expected both this year and next. Encouragingly, the UAE operation has returned to profit in H116. The situation in Iraq remains constrained by administrative inertia as recovery terms in contracts between the concession holders and the government are being renegotiated. As a result, Medserv management is implementing a cost-saving programme to address the low volumes while maintaining longer-term capability.

Overall METS continues to meet expectations, and a full six-month contribution will benefit H216, with a full year contribution also enhancing FY17. Synergy potentials between the traditional shore-base operations of Medserv and the OCTG services of METS are also progressing.

The board has approved a significant change in executive responsibilities. The roles of the two principal director shareholders, Anthony Diacono and Anthony Duncan, have been adjusted. Mr Diacono will become group CEO as well as maintaining his role as chairman. Mr Duncan will maintain his responsibility for finance, but will also incorporate the new and increasingly important role of compliance.

To provide a progressive succession at the company, Karl Bartolo, the current CFO, has been appointed chief executive designate with a view to him assuming the role in three years’ time. He has been with Medserv since 2008 and in recent years has become increasingly involved with the commercial elements of its activities.

Godwin Borg has been appointed to the board and has signed a two-year consultancy agreement with Medserv, relinquishing his role of COO, which is being abolished. Instead three regional heads will serve the Mediterranean, the Middle East and other International. The reorganisation aligns management responsibility and accountability more closely with regional activity as the opportunities for Medserv continue to expand globally.

Our capped DCF currently returns a value of €1.90 per share using a WACC of 7.9% and terminal growth rate of zero. The WACC has reduced slightly due to the modestly higher proportion of debt funding than we previously expected. The sensitivity of this value to differing assumptions for the WACC and terminal growth rate is shown below, with the closest value to our calculated assumption highlighted.