China Oilfield Services:H/A,Reduce,connected transaction limits signal 2017revenue risk

2017e looks even tougher than expected given shrinkingconnected party transaction limits with CNOOC Group

    In addition the company will be removed from HSCEI and seea possible credit downgrade by Moody’s

    Maintain Reduce on COSL-H/A with unchanged TPs ofHKD5.25/RMB4.6

    Event: COSL has experienced a wave of negative news over the last week.

    Firstly, last week, the new Service Framework Agreement (SFA) on 9 November2016 set significantly lower connected transaction limits with CNOOC Group (883HK, HKD9.51, Reduce). Two other negative inputs were received (11 Nov 2016,Reuters): Effective 5 December 2016, COSL will be removed from Hang SengChina Enterprises Index (HSCEI) due to lower liquidity and market capitalization,which may pressure the shares; and Moody’s announced that COSL’s credit rating ison review for a further downgrade after it was cut from A3 to Baa1 in December 2015in reflection of the impact of low oil prices on corporate liquidity and profitability.

    Implications: The outlook for COSL’s operations remains challenging, despiteshare price resilience in the face of a steady stream of negative news flow. Theloss in 9M16 reached a record RMB9bn as upstream clients lowered spending. Otherindicators including rig utilizations (-21% y-o-y in 3Q16) and Operating Margin (-18%in 3Q16) also reflect ongoing industry headwinds. Even with the 1H16 crude oil pricerebound, COSL’s operations remain under significant pressure as the industryspending outlook remains subdued. In 2015 COSL generated 65% of revenue fromCNOOC Group. Proposed transaction caps between COSL and CNOOC Group in2017e are only half the 2016 limit. Further, historically, COSL’s actual revenuegeneration has been well below the intra group transaction limits. In 1H16, COSL’sconnected party revenue was only 30% of proposed annual cap, while CNOOC 9M16outlays represented 56% of its FY16 capex budget (RMB60bn). The announcementof COSL’s removal from HSCEI and potential credit action from Moody’s may createadditional pressure on the share. Upstream investment outlays are highly sensitive tooil price volatility; upstream capex budgets are likely to remain tight. We believe it istoo early to call a recovery before finding evidence for fundamental improvements.

    Valuation and risks: maintain Reduce on both COSL-H/A with TPs ofHKD5.25/RMB4.6. We derive our H-share TP by applying a 5.7x 2yr Forward P/CF,the average trailing multiple at which the stock traded since 2011. To derive our Asharetarget price, we convert the H share target price using a HKD:RMB cross of1.13x. Upside risks for H/A shares: Higher oil prices, Chinese government equitymarket support, expanding valuation multiples, narrowing H-share discount, recoveryin E&P capex budgets, rising rig scrap rates, improvement in rig utilizations and dayrates, industry consolidation, etc.