Buy China Oilfield Services

1 August 2017 Oil & Gas China Oilfield Services Deutsche Bank Markets Research Rating Company Date Buy China Oilfield 1 August 2017 Recommendation Asia Services China Change Reuters Bloomberg Exchange Ticker Price at 31 Jul 2017 (HKD) 6.66 Energy 2883.HK 2883 HK HSI 2883 Price target - 12mth (HKD) 8.57 Oil & Gas 52-week range (HKD) 8.48 - 5.87 HANG SENG INDEX 26,979 Cost cuts and new contract wins to revive earnings growth; U/G to Buy Valuation & Risks Johnson Wan Lower costs + CNOOC support + new overseas contracts = 2018 turnaround After losing money for the last 1.5 years, COSL returned to a slight profit of Research Analyst RMB148m in 2Q17. We believe this is a direct outcome of aggressive cost cuts, +852-2203 6163 both operating and non-operating, over the last three years, which have prepared COSL for a lower-for-longer oil price environment. COSL's reduced cost base Vitus Leung has made it highly competitive when bidding for overseas contracts starting in Research Analyst 2017. COSL secured three new semi-sub contracts in July 2017 and has now +852-2203 6158 signed eight contracts ytd outside of CNOOC overseas. COSL is also benefiting from increased activity at CNOOC, which increased infield drilling in 1H17 in Key changes accordance with its c.20% yoy capex growth target for 2017. While the offshore Price target 5.09 to 8.57 ↑ 68.4% drilling market remains oversupplied, we think the worst is now over for COSL Rating Sell to Buy ↑ and we expect a strong earnings recovery in 2018. Upgrading from Sell to Buy Sales (FYE) 17,332 to ↑ 1.1% with TP of HKD8.57. 17,521 Op prof margin -2.5 to 4.8 ↑ -287.1% (FYE) New contract wins overseas pave way for utilization rebound Net profit (FYE) -1,192.0 to 48.1 -104.0% Based on our analysis of COSL's contract signings per rig as of July 2017, COSL ↑ Source: Deutsche Bank has already locked in contracts to boost utilization rates to c.58% and c.69% for semi-subs (SS) and jack-ups (JU), respectively, in 2017, exceeding COSL's Figure 1: EPS: DB versus consensus targets of 50% and 60-65% for 2017. For comparison, SS and JU utilization rates (RMB/sh) DBe Cons % diff were 32% and 53% in 1Q17 and stood at 40% and 56% in FY16, suggesting a FY17 0.010 -0.062 NA sharp recovery in utilization rates in 2H17. Further, new contract wins overseas by FY18 0.400 0.162 147% COSL's European subsidiary (CDE) in Norway have been a positive surprise; it has FY19 0.740 0.276 168% secured contracts with both Lundin Petroleum and Nexen for 2018 work using its Source: Deutsche Bank, Bloomberg Finance LP Innovator and Pioneer rigs. Its Nanhai VIII rig also won contracts with Gazprom for four months of work in 2H17, with Russia emerging as a new source of revenue Our TP of HKD 8.57 is based on a WACC growth in 2018. Based on the current new contract signings and assuming that of 7.6%, using a CoE of 12.0%, an after-tax CNOOC will reward COSL with the same amount of work in 2018 as in 2017, CoD of 2.8% and a three-year beta of 1.45 (vs. the HSI). We apply 1% terminal growth utilization rates for SS and JU should rebound to c.66% and c.70%+, respectively. for COSL. Risks: lower-than-expected capex spending by CNOOC; contract cancellations. Cost cutting was likely the surprise in 1H17 results COSL reported a significant decline in losses to -RMB370m for 1H17. The result was likely due to better-than-expected cost cuts rather than revenue generation, as operating numbers in 1Q17 were rather soft. We believe COSL is on track to cut another c.10% or RMB1bn in costs in 2017 after shedding RMB1bn and RMB3bn in 2016 and 2015, respectively. The deep cuts should enable COSL to break-even in 2017 alongside increased workload. The areas where we expect further cost cuts are a reduction in employee costs, lower subcontracting expenses as less work is outsourced, lower operating lease expenses with contract renegotiations for its leased ships, and lower materials costs. Further, we believe COSL has Deutsche Bank AG/Hong Kong Distributed on: 31/07/2017 19:21:07 GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. 0bed7b6cf11c 1 August 2017 Oil & Gas China Oilfield Services already provisioned for RMB8.3bn in 2016 and that further impairments will not be necessary in 2017; we even see the potential for some accounts receivable writeback from its Statoil contract loss last year, though we have not modeled this for the moment. Market still oversupplied but shallow depth rigs have recovered With oil prices stabilizing at USD50/bbl, global utilization rates for semi-subs hit a trough of 56.8% in Dec 2016 and those for jack-ups troughed at 46.7% in Jan 2017. They have since started to recover: July 2017 utilization rates have improved to 59.4% for JU and 51.4% for SS, up 3 ppts and 5 ppts from the troughs, respectively. However, day rates have continued to decline, with June 2017 day rates for JU and SS at USD71k/d and USD162k/d, down 11% and 35% yoy. That said, day rates for shallow water depth rigs (JU ≤ 300 ft and SS ≤ 3000 ft) have already rebounded and are now up 24%-32% yoy. COSL currently has 63% and 48% of its SS and JU rigs in the shallow water category. Forecasts and ratios Year End Dec 31 2015A 2016A 2017E 2018E 2019E Sales (CNYm) 23,416.7 15,238.8 17,520.7 20,392.8 23,323.2 EBITDA (CNYm) 7,614.9 1,425.1 5,290.1 7,183.8 9,057.5 Reported NPAT (CNYm) 1,073.9 -11,456.2 48.1 1,919.8 3,541.2 DB Net Profit (CNY) 2,756.1 -3,452.2 -71.9 1,919.8 3,541.2 Reported EPS FD(CNY) 0.23 -2.40 0.01 0.40 0.74 DB EPS FD(CNY) 0.58 -0.72 -0.02 0.40 0.74 OLD DB EPS FD(CNY) 0.46 -0.96 -0.25 0.07 0.35 % Change 25.9% -24.6% -94.0% 470.7% 112.9% DB EPS growth (%) -65.5 – 97.9 – 84.5 PER (x) 15.6 – – 14.3 7.7 EV/EBITDA (x) 8.5 36.6 10.0 7.3 5.5 DPS (net) (CNY) 0.07 0.05 0.07 0.20 0.26 Yield (net) (%) 0.8 0.9 1.2 3.5 4.5 Source: Deutsche Bank estimates, company data Page 2 Deutsche Bank AG/Hong Kong 1 August 2017 Oil & Gas China Oilfield Services How has COSL turned the corner? Profit generation begins with cost cutting After losing money for the last 1.5 years, COSL returned to a slight profit of RMB148m in 2Q17. We believe this is a direct outcome of aggressive cost cuts, both operating and non-operating, over the last three years, which have prepared COSL for a lower-for-longer oil price environment. COSL's reduced cost base has made it highly competitive when bidding for overseas contracts starting in 2017. We believe that the better-than-expected 1H17 results, with COSL reporting a significant decline in losses to -RMB370m, were not a function of revenue growth (as seen from soft 1Q17 operating data) but rather to do with further cost cuts. Operating cost cuts - We believe COSL is on track to cut another 10-15% or RMB1bn in costs in 2017 after shedding RMB1bn and RMB3bn in 2016 and 2015, respectively. The deep cuts should enable COSL to break-even in 2017 alongside increased activity. The areas where we expect further cost cuts are a reduction in employee costs, lower subcontracting expenses as less work is outsourced, lower operating lease expenses given contract renegotiations for its leased ships, and also lower materials costs. From its peak in 2014, COSL has cut c.30% in operating costs. Figure 2: COSL's operating expenses Figure 3: COSL's impairments and one-offs vs. its profit RMB mn RMB mn 30,000 25% 10,000 20% 25,000 15% 5,000 20,000 10% 5% 0 15,000 0% 10,000 -5% -5,000 -10% 5,000 -15% -10,000 0 -20% 2011A 2012A 2013A 2014A 2015A 2016A 2017E -15,000 Other Operating Subcontracting 2011A 2012A 2013A 2014A 2015A 2016A 2017E 2018E 2019E Office Operating lease Employee Repair and maintenance Core NP Reported NP Impairments incl. exchange loss Depreciation & Amortization Consumption of materials, fuel, services Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank Non-operating cost cuts - COSL made heavy provisions of RMB8.3bn in 2016 and we do not rule out the possibility of AR write backs of RMB1.1bn in 2017, such as for its Statoil contract cancellations, though we have not modeled this in for the moment. Since 2014, COSL has made provisions amounting to RMB10.5bn for property, goodwill, receivables and inventories. Therefore, we do not expect further impairments in 2017 for COSL, with increased work activity.

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