Earnings tsunami, +40% EPS CAGR over FY11-13F. We see Nam Cheong's net profit doubling over the next two years on the back of strong vessel sales since the bottom in 2009. The growth will be driven by increasing vessel deliveries from 13 to 19 per year as well as building higher-value vessels.

'Letter of Authorisation' system for Malaysian builders allows Nam Cheong's customers to bid for contracts using its unsold vessels, and upon contract award to immediately purchase the vessel. With a short time to delivery because of its build-to-stock model, Nam Cheong is a preferred OSV builder even amongst competing charterers.

80% increase in Petronas capex forms a solid industry backdrop. Petronas has budgeted RM300b for capital expenditure over the next five years, a full 80% increase over the previous five, in response to its falling oil production. This provides a massive stimulus package to the entire Malaysian oil & gas industry.

Valuation: TP $0.290, strong candidate to double in 2-3 years. Our target price is based on a P/E of 8.5x on blended FY12F/13F EPS, which is an undemanding multiple for the industry leader in Malaysia. On the current growth profile, the same multiple on FY14F EPS of 4.2S'' will result in the share price doubling to $0.360. Key risks include a higher risk business model as well as lumpy results between quarters based on vessel sale dates.

Dominant OSV builder in Malaysia. Nam Cheong is the largest builder of Offshore Support Vessels in Malaysia, with a market share between 50% and 75%. Vessels are built in its shipyard in Miri, East Malaysia, as well as in partner Chinese yards. Quality is ensured by Nam Cheong's supervisory staff on the ground, using only globally-recognised branded equipment, as well as certification by global classification societies.

Nam Cheong delivers between 12 and 21 vessels a year. The current building programme includes Anchor Handling Tug Supply (AHTS) vessels, Platform Supply Vessels (PSVs), and Accommodation Work Barges (AWBs). Shipbuilding accounts for about 95% of FY12 forecast revenues.

OSV Charter Fleet. Nam Cheong owns and operates a small fleet of 10 Standby Support Vessels (SSVs), two Landing Crafts and one AHTS. All 13 vessels are currently chartered to service oil platforms in Malaysia and Brunei, with the AHTS in the Middle East. Charter income accounts for 5% of FY12 forecast revenues.

Build-to-Stock model. Nam Cheong builds its vessels ahead of firm orders, and sells the vessels at a premium due to the short time to delivery. In its 44 years of shipbuilding, with the last 23 spent building OSVs, Nam Cheong has built up an extensive network in the oil & gas industry, allowing it to anticipate future needs and to plan newbuilds appropriately. It has sold every single OSV upon completion, pointing to the success of this strategy.

Key operational driver is the timing of vessel sales. When vessels are sold, all the work done to date is recognised immediately in revenue and profits, with future progress recognised on a percentage-of-completion method. A vessel near completion would contribute a large amount of profit at once. This introduces a high degree of lumpiness in inter-quarter results. Sharp share price increases have also followed vessel sales.

Rising tide of earnings, +40% EPS CAGR over FY11-13F. We see Nam Cheong's net profit doubling over the next two years on the back of strong vessel sales since the trough in 2009. Revenue and profits tend to lag vessel sales by two years, and the extremely low sales in 2009 bottomed performance in 2011. Since then, 2010 and 2011 saw a strong recovery in vessel sales, which is driving the earnings leap this year.

High margin business model. By building ahead in China, Nam Cheong offers its customers a shortened time to delivery at low cost. This allows the OSV-building gross margin to be maintained around 18%, which is at least 5ppt above the norm today. Its niche charter fleet of SSVs averages a very high gross margin of 80%.

Highly scalable business without losing quality: Nam Cheong engages a number of partner Chinese yards to build the majority of its vessels, and thus its effective capacity can be scaled up and down quickly without incurring fixed costs and capex. At the moment, it is currently contracting only three out of the six partner yards in China it has historically used, indicating a potential to scale up in better times. It maintains the build quality by having its supervisors on the ground, using only branded equipment, and by having its vessels certified by global classification societies.

'Letter of Authorisation' system for Malaysian builders allows Nam Cheong's customers to bid for Petronas contracts using its unsold vessels, and upon contract award to immediately purchase the vessel. This gives Nam Cheong a massive advantage over foreign OSV builders, and over local competitors without a large ready stock of vessels. Furthermore, its vessels are immediately Malaysian-flagged, in compliance with the cabotage laws, saving customers the costs and hassle of reflagging.
Impeccable 44 year track record, 25 years in OSVs: Nam Cheong began building ships in 1968, and delivered its first SSV in 1987. Its long years in the industry have secured intangible assets in experience and relationships which contribute to its market dominance.

80% increase in Petronas capex forms a solid industry backdrop. Petronas has budgeted RM300b for capital expenditure over the next five years, a full 80% increase over the previous five, in response to its falling oil production. The system of subsidies in Malaysia has caused an ongoing fiscal deficit partly mitigated by Petronas dividends, but according to BP numbers, oil/gas production fell 10.9%/1.3% in 2011, putting future cashflows at grave risk. Petronas CEO Datuk Shamsul has publicly promised a reduction in dividends, channelling the cash to capital expenditure. The increased budget provides a massive stimulus package to the entire Malaysian oil & gas industry, and we see Nam Cheong as the primary beneficiary in the OSV segment owing to its dominance.

Current valuations are backward-looking; 55% upside. Nam Cheong was listed only in May 2011, and we believe the general lack of market familiarity with this name has caused valuations to be backward-looking at 9.6x 2011 EPS. On a forward basis, Nam Cheong is trading only at 6.1x/4.9x FY12F/13F earnings. Our TP of $0.290 offers a 55% upside, and the 2% dividend is a sweetener while waiting for the market to realise the true value of this company.

Strong candidate to double within three years. We forecast Nam Cheong's EPS at 4.2S'' in FY14F, and at the same 8.5x multiple the price would be almost double at $0.360. Even then, there is still further upside in both the multiple (which is low for a company growing at 30% a year) and in earnings (potential surprises in higher vessel prices, more vessels being built, and vessels of higher value being ordered).

Our earnings model is based on fitting each vessel in the forecast building programme to an 'S-curve' which approximates a percentage-of-completion revenue recognition profile. As Nam Cheong employs a build-to-stock model, the timing of vessel sales becomes critical to revenue recognition. We assume that vessels to be delivered this year are sold 0-2 quarters before completion, and 2-3 quarters for delivery years beyond 2013.

Total revenue to jump 92%/21% in FY12F/13F to RM1,164m/1,415m from RM606m in 2011 largely because of increased shipbuilding revenue. Due to the record low number of orders in 2009, revenue recognition in 2011 suffered with many vessels on the tail-end of the S-curve in that year. Vessel deliveries were also a very low 13. The jump to delivering 18/19 vessels in FY12F/13F is a primary reason for the performance boost.

Growth strategy to scale the value chain. The growth in shipbuilding revenue in FY13F/14F will derive from Nam Cheong building higher-value vessels, on top of a slight increase in deliveries to 19 and 20 vessels. Broadly speaking, we are forecasting a general
shift away from small AHTS vessels towards PSVs, and building more mid-sized 12,000bhp AHTS as well as more high-value 300-men AWBs.

Performance already shifting into high gear. Nam Cheong's revenue tends to lag vessel sales by two years ' note the revenue trough in 2011 following the 2009 sales in Figure 5 below. Since then, vessel sales have recovered to near pre-crisis levels. 1H 2012 revenues, at RM329m, are 68% above 1H 2011 figures.

High-margin business. Nam Cheong's core shipbuilding business garners a gross margin between 15% and 20%. This is high by industry standards, where the average is 10%-13% today, due largely to its low-cost partner yards in China. Its charter fleet of specialized SSVs currently enjoys an 80% gross margin, such that this small segment contributes almost a fifth of gross profits, but at the bottom line shipbuilding delivers more than 90% of the profits because of the faster depreciation on the vessels.

Our estimates are conservative. Though Nam Cheong achieved a shipbuilding gross margin of 18.6% in 2011, for conservativeness we have assumed only 16% for all future years. The move towards building more PSVs actually hints towards higher future margins,
but given the current economic climate, we prefer to err on the side of caution and to incorporate a larger margin of safety.

Margins stable come high water. Nam Cheong has achieved overall gross margins of 15%- 23% over the last five years even through the financial crisis. We attribute this fine performance to the scalability of the business model ' in tough times, capacity can be reduced at zero cost by simply not ordering from a partner yard. There are no large fixed costs, yard and equipment depreciations, cash burns, etc. to depress margins and cashflows unlike for other shipbuilders. Going forward, we see gross margins maintained at a stable 17% - 19% range.

More flowing through to the bottom line: Nam Cheong's cost controls have demonstrated a clear trend of improvement. In FY09, overheads (loosely defined as the difference between the gross and net margins) were 9.2% of revenue, falling to 7.1%/7.4% in FY10/FY11, and we are projecting future overheads for FY12F-14F at 6.3%, 5.8% and 5.5%. The main reasons for the improvement are lower administrative costs (related to ship brokerage, etc.) as well as a more efficient tax structure for the increasing number of vessels built in China.

Nam Cheong's net margins are currently between 12% and 16%. This is an enviable achievement ' many other OSV builders are looking at gross margins of 10%-13%, and merchant-vessel builders are faced with a choice of low single-digit margins or empty yards. Again, the easy scalability of Nam Cheong's business model works to its advantage at the bottom line.

Watch out! 58% EPS jump incoming! We forecast FY12F PATMI at RM147.1m, a 57.9% improvement over FY11's RM93.2m which we see as the trough in Nam Cheong's earnings. FY13F offers a significant 23.8% improvement to RM182.1m for a 2-year CAGR of 40%. We strongly believe that the massive earnings improvement will provide the catalyst for a shareprice re-rating in the near future.

Market pricing the stock backwards. At the current price, the market appears to be willing to price Nam Cheong at 9.6x FY11 EPS, which is a fair multiple given the current global macroeconomic conditions. The closest OSV-builders are trading near this multiple on a forward basis. However, the price has clearly not incorporated the 58%/24% jump in EPS which brings the forward P/E for Nam Cheong down to only 6.1x for FY12F, and 4.9x for FY13F.

We value Nam Cheong at 8.5x blended FY12F/13F EPS of 3.45'' for a target price of $0.290. We view SGX-listed STX OSV as the nearest comparable as it is a pure OSV builder, and though the product offering differs vastly in technical specification, both companies enjoy dominant positions in their respective markets ' STX OSV in bespoke high-end vessels, Nam Cheong in its native Malaysia. STX OSV is trading at a FY12F/13F blended EPS of 8.8x based on DMG estimates and we feel that Nam Cheong should be valued similarly.

55% upside today, strong candidate to double or more in 3 years: On FY12F earnings alone, our 8.5x multiple provides for a 55% upside. Our EPS forecast for FY14F is 4.2'', and at the same multiple the stock price would nearly double to $0.360. Further upside is possible ' our 8.5x multiple is fairly low for a company growing its EPS at 30% a year, and our FY13F/14F figures could see upward revision if vessel prices improve, if Nam Cheong builds more vessels or if it wins orders for higher-value vessels than forecast.

Vessel sales not materialising. Historically, Nam Cheong has managed to sell all its vessels before their completion date. However, history does not guarantee the future, and failure to sell enough vessels within the forecast period could cause an earnings miss. Operationally, this is unlikely as the company can still sell vessels at the market price while offering a short delivery time at little premium, translating into a major competitive advantage.

Business model inherently riskier. Higher risk, higher returns. Speculative building brought Jaya Holdings to the brink, and DryDocks beyond it. The key risk is cash ' speculative building burns cash first with an uncertain sale date, increasing leverage throughout the process. Even so, build-to-order is not riskless ' orders can be cancelled. The back-end-loaded payment terms, usually 20% deposit and 80% on delivery, also require the builder to manage its own cashflows.

Nam Cheong manages this risk through maintaining a detailed working knowledge of the industry's requirements, built up over the last 25 years of OSV construction. Its dominant position in Malaysia also helps reduce the overall business risk, and the 'Letter of Authorisation' system is a local advantage neither Jaya nor Drydocks enjoyed.

Newbuild demand subject to various fears. In the long run, the demand for OSVs is positively correlated with the oil price. Its recent volatility, combined with financing difficulties faced by many shipowners, has delayed order wins.

Fortunately, the picture for the oil industry is positive. World demand exceeds supply, and even today with the US/EU areas in trouble and China slowing down, the oil price is still above $100. We do not see any sustained fall in the oil price below $70, which is a critical level that determines whether oil majors continue their expansionary capital expenditure budgets.
The financing issue is a real risk that is less within control. Another protracted dislocation, like the one in 2008/09, could severely disrupt the capital-intensive offshore industry.

Chinese competition in the small-OSV space. While China still struggles to build good-quality high-specification OSVs, it is currently flooding the market with small offshore vessels, with about 60% of the 150 small-sized AHTS vessels on the global order book being built in China.

The main reason the Chinese cannot dominate the market is quality. Chinese vessels built unsupervised by skilled and experienced foreign builders tend to be of a much lower quality, and are not well accepted outside of Chinese waters. They do not pose an immediate competitive threat. Further, the cabotage laws in Malaysia serve as an additional layer of protection for local builders against foreign competition.

The main concern is long-term. Chinese builders will eventually learn to build quality vessels, and their fearsome ability to mass-produce vessels of acceptable quality in the merchant space (tankers, bulkers, containerships) has allowed them to secure a dominant position. Nam Cheong will need to stay a few steps ahead, building higher-value, higher-specification vessels and/or diversifying into building higher-specification, bespoke vessels.

Nam Cheong enjoys more than 50% of the OSV market share in Malaysia based on average gross tonnage produced from 2008 to 2010. For 2011, company management informs us that the market share figure rose to 75%.