Medserv — Update 10 June 2016

Medserv is quoted on the Malta Stock Exchange. It provides a variety of logistics and support services to international oil companies (IOCs) and contractors operating offshore in the Mediterranean region. It operates from bases in Malta, Portugal and Cyprus, with a representative office in Libya. To mitigate some of the cyclicality and the uneven nature of its existing business, the company recently developed its strategy to include the servicing of upstream onshore oil production and exploration in the Middle East “easy oil” markets (known-oil locations on-shore). Due to lower extraction costs these operations tend to be rather less affected by changes in the oil price.

The strategy has seen the acquisition of Middle East Tubular Services and its subsidiaries (the METS companies) for $45m (see page 7). METS offers integrated oil country tubular goods (OCTG) services to the onshore market from bases in Oman, Iraq and the UAE. The purchase was completed on 23 February 2016, increasing Medserv’s revenues by approximately 50% on an annualised basis. While operating margins of 12.8% in the year to April 2015 were lower than those achieved by Medserv in 2015 (17.8%), the activity has reasonable visibility, is comparatively stable and generates healthy cash flows. As well as cross-selling opportunities in each company’s respective locations, METS also provides a further opportunity to expand operations geographically.

The decline in the oil price has increased the uncertainty surrounding oil field services. Due to the sensitivities surrounding the geographies in which it operates, we have adopted risk adjusted valuations, notwithstanding those already applied to oil and gas exposures more generally. Our capped DCF methodology returns a value of €1.83 per share.

If the political and financial risks in its countries of operation were to diminish, the upside potential for valuations could be substantial. However, while we are not experts on the political situation in Libya, or any of the high-risk register countries in the Middle East and North Africa, we know that both Medserv and METS are well-respected providers of services, and would likely be major beneficiaries of any increase in oil activity that greater stability might stimulate.

The company has just released its forecast for FY16. While this reflects the pressure on Medserv’s ongoing activities arising from the global retrenchment in investment by upstream oil and gas customers, the 10-month initial contribution from the recently purchased METS companies should more than compensate in revenues and EBITDA terms. A drop in gross margin has been offset by a reduction in administrative costs. The operating comparison with many offshore service companies elsewhere in Europe is thus relatively favourable. We expect moderate growth in the medium term from the ongoing activities that could be significantly enhanced by expansion into new territories.

While it should be noted that not only is Medserv operating in a macro-affected oil and gas market, as well as in geopolitically sensitive regions, it has long-established relationships with both the major IOCs and NOCs to whom it provides services. ENI’s upstream activities historically account for c 50% of revenues. The acquisition of METS extends these regional issues, and adds Sumitomo as a major customer. The established relationships and technical necessity of METS’s service offering provide an element of resilience in all but the worst of circumstances.

Medserv Limited was established in 1974 as a joint venture between the Maltese government (65%) and Albert Abela Group (35%), a privately owned company, which subsequently bought out the government stake in May 1997.

In 2001 AD Holdings Limited (later renamed Medserv plc) was granted options by Albert Abela Group to purchase the entire equity of Medserv Limited (later renamed Medserv Operations Limited), a transaction that was completed in 2003. In autumn 2006 Medserv plc sold 2.5m shares (25% of the issued capital) via an IPO at the equivalent of €0.66 per share, allowing for subsequent capitalisation issues and the recent rights issue.

During the entire period since incorporation, Medserv has provided integrated oilfield support and services to the upstream operations of IOCs and NOCs operating in and around the Mediterranean region, principally offshore. Historically, its primary customer is ENI, the Italian energy oil and gas major, operating as three distinct entities in the upstream, exploration and production (E&P) markets. ENI is the leading offshore IOC operating in the Mediterranean, and has extensive relationships with the Libyan oil industry in particular.

Medserv plc is the group holding company, which holds all but one share in each of its operating subsidiaries, with the founder shareholder being the second shareholder as required under Maltese corporate law. As shown by the group structure in Exhibit 1, Medserv holds its foreign operating subsidiaries through Maltese registered sub-holding companies. The major current operating subsidiary companies are Medserv Operations Limited (MOL), a company based in the Freeport of Malta, Medserv (Cyprus) Limited, which is the operating company of the Cyprus operations supporting ENI Cyprus and MDS Energy Portugal Unipessoal LDA providing shore-based facilities in Portugal. Medserv M.E. Ltd was incorporated in 2015 and acts as the parent company for the recently acquired METS operating companies.

Medserv Eastern Mediterranean owns 80% of Medserv (Cyprus). The balance is held by Caramondani Group, a diversified engineering company based in Nicosia. Set up in 2011, Medserv (Cyprus) operates Medserv’s shore base facility at the port of Larnaca. Essentially a replication of the Malta facility, Larnaca operates a base, which to date supports ENI Cyprus’s offshore drilling programme. ENI had its existing drilling licence for three offshore blocks extended by two years in February 2016, so while Larnaca is being temporarily mothballed with the lease expiring in August, interest in the region is expected to be reactivated by recent substantial gas finds offshore Egypt. These finds are close to Cypriot licenced blocks where a third bidding round began in March. Interest in Medserv’s presence in Cyprus from other IOCs was also apparent in the recently released interim statement. The future dock-based operations may be transferred to Limassol to service any new activity, with a leased storage facility possibly maintained at Larnaca.

Medserv closed its onshore Libyan base at Misurata in 2014 and sold its 60% holding in the operating company last year. Of the other operating companies, Medserv Libya still has an office in Tripoli, established towards the end of 2013, which provides administrative services and tax representation in-country for oil and gas contractors operating offshore Libya.

Medserv Italy is the parent of a 50:50 joint venture with Filgest, based in Sicily to provide logistics and support facilities to service an anticipated increase in offshore E&P activity in the area.

MOL has a unique position in the Freeport of Malta operating under an extended emphyteutical deed (see the Maltese lease arrangements on page 5). MOL provides the full suite of offshore services to IOCs and NOCs principally operating in waters offshore Libya. Many of them withdrew from Libyan onshore bases in 2014 due to renewed political tensions, relocating to Malta and leading to significant share gains for Medserv and high utilisation of the Marsaxlokk base. It serves a high-quality customer base that includes ENI North Africa, Mellitah Oil & Gas (MOG, a joint venture between the NOC of Libya and Eni), Newpark Drilling Fluids, Halliburton, Bakers Hughes, Transocean, GEV Offshore, Saipem, Technip, Cameron, FMC and Schlumberger. A contract in support of a single well drilling operation can typically range in value from €1m-4m contingent on the scale and nature of the operation and the services provided.

Medserv has several differentiating factors that position it uniquely in its Mediterranean base.

First, its Malta base is centrally located in the Mediterranean basin. It is close to both Italy and the offshore Libyan oilfields, which is a strategic advantage given the strong historical relationship between those two countries and their oil and gas interests. It also has allowed Medserv to pursue other support activities in both the eastern Mediterranean through its facility in Cyprus, and further west such as the upcoming development of a new base to support drilling of a single well in the Atlantic offshore of Portugal later this year.

Second, the extended lease arrangements with the Maltese government provide a significant barrier to entry for competition in the Maltese market. This is largely due to the 239 metre deep water dock facility and substantial warehouse and yard facilities in the Freeport at Marsaxlokk, which provide a stable and relatively inexpensive operating base.

Third, with four decades of operational experience it allows Medserv to optimise and then replicate its operating model in new locations as the opportunities to support drilling arise.

In Malta, Medserv operates in the Malta Freeport in the Port of Marsaxlokk, at the south of the island. It benefits from an emphyteutical lease deed initially granted to the company until 2046. A emphyteutical lease is granted for a long period with certain conditions that may require improvement to the leased property, normally with respect to construction. In 2012, the lease deed was extended for a further 15 years until 2060, subject to certain employment and investment levels being met. The conditions included investment of €9m at the site as well as employing in excess of 90 full-time equivalents. Both conditions were met by the end of 2014. The investment included the construction of a photovoltaic farm, which generates €534,000 per year of other income for Medserv.

Following the extension of the deed in 2012, the lease was commercially valued based on property rights held by the group over land and industrial properties at the Malta Freeport. The lease’s fair value was capitalised at the start of FY13 at an initial fair value of €40.3m, less the carrying amount of facility improvements of €3.1m included in property plant and equipment. It is being depreciated over the grant period to 2060, at an annual rate of €775,533.

The depreciation together with an offsetting amount of deferred income is recognised in the P&L in the other income line.

In terms of the services provided, these can be split into four categories:

Shore-based logistical support

At the historic core of the company in Malta and replicated at its base in Cyprus, Medserv offers integrated offshore logistics from its onshore bases in support of drilling operations. Although activity in Cyprus is being mothballed until drilling activity by ENI Cyprus picks up again, the company expects to replicate this offering if contracts are awarded in new territories (eg, Egypt and Trinidad & Tobago). The main services are a dedicated quayside, laydown yards and warehousing for pipes and equipment, inspection services, transport, cranes, the handling of drilling fluids, provision of bulk chemicals and the availability of specialised cargo container units. Medserv also operates two multi-user mud plants at its onshore base in Malta that formulate, mix and store drilling muds for offshore rigs, primarily for those in Libyan waters but also for other parts of the world.

Rig and vessel stops

Medserv provides logistics services for mobilising and demobilising oil rigs and platforms, platform supply vessels (PSVs) and for other oil and gas vessels. The scope and scale of revenues can vary significantly per stop depending on the purpose of the stop and the services undertaken.

Offshore maintenance

Since 2011 Medserv has provided engineering support services to rigs and platforms operating in waters offshore Libya and Egypt. Services offered include welding and fabrication, inspection, procurement, project management and personnel, dredging, painting and OCTG maintenance and storage.

Other services

Other services are essentially the bunkering of marine fuel, which can vary significantly in revenue terms, but generates only low single-digit pass through margins. Medserv also provides environmental services in the form of waste management for the receipt, handling and disposal of waste generated by offshore operations.

The volatility and lumpiness of Medserv’s operations are reflected in the development of Medserv’s revenue streams since 2008 and shown in Exhibit 5 below. The fluctuation of activity supporting offshore Libya and Cyprus drilling operations are the main factors, although the 2016 forecast includes the new base in Portugal to support a new exploratory well to be drilled in H216.

The income of just over €0.5m per year from the feed into the grid in Malta from the photovoltaic farm is included in other income, not Medserv’s revenues. Commissioned in 2014, the farm generates electricity from solar panels installed at the Marsaxlokk base that is sold at a fixed rate on the national grid for a period of 20 years, expiring in 2034.

The split of revenues by geography and service type for Medserv’s ongoing activities, including METS, are shown in Exhibits 4 and 5 below:

The acquisition of the four British Virgin Island registered companies that form the METS companies (Middle East Tubular Services) for $45m was completed on 23 February 2016. Medserv acquired 100% of the capital of the group companies with the exception of METS Iraq, where 90% was acquired, with the remaining 10% being retained by Jarrett Asset Holdings Corporation, a founding member of the operation in Iraq.

The founder of the METS Group, Paul Hayward, remains chairman of the METS group of companies. Gareth McMurray retains his position as regional general manager to ensure the continued growth and success of the METS group in the Middle East.

In our view, the purchase of METS furthers the strategy of Medserv in four key areas. It:

Established in Sharjah in 2006, METS is a leading stockholder and supplier for the OCTG market used in the onshore oil and gas industry. It operates from branches in three free zones around the Persian Gulf: Hamriyah in Sharjah (UAE), Al Qabail in Sohar (Oman), and Khor Al Zubair in Basra (Southern Iraq).

It holds around 140,000 tonnes of customer OCTG stock in its three bases. Offering an integrated approach, its operations can be split into three complementary activities:

It also stores oilfield equipment such as rig packages and offshore accommodation units. Machine shop operations include contracts to manufacture various tube components and accessories, as well as carrying out repairs. Customers include majors such as BP, Lukoil and Shell, and OCTG producers including Sumitomo and Marubeni. Pipe trading companies as well as smaller independents also use the yards and handling services.

The METS companies are established as three location-based commercial subsidiaries operating independently under the parent holding company, with management oversight based in the UAE.

The operations have good visibility of required volumes and are regarded as low risk in an essential category, with expansion potential into new and developing production locations. The geographic split of revenues and historic performance are shown in Exhibit 7 and Exhibit 8.

The acquisition was financed by a bond issue raising net proceeds of €29.5m and the balance from a contemporaneous 2-for-9 rights issue of 8.7m new shares at €1.50 per share, which raised net proceeds of c $12.6m. A $3m at-risk deposit had been paid on the initial agreement so was included in the FY15 year-end net debt calculation. The net consideration is thus $42m or €36.5m (total consideration paid was thus $45m or €39.1m). The deal was subject to a “locked box” shareholder agreement so value accrued to Medserv until completion. Using the FY16 forecast recently released, we can deduce from the fixed asset increase, level of goodwill and year-end cash balance expectations that METS is likely to have contained c €7.0m of cash and realisable cash equivalents in its net current assets. Adjusting for this assumed cash gives an EV of c €32m.

Taking the FY16 forecast for METS and annualising it to a 12-month contribution, Medserv paid an EV/sales multiple of 1.96x (or 1.6x adjusted for the cash assumption), and EV/EBITDA multiple of 9.3x (or 6.4x adjusted for cash acquired). With METS expected to achieve EBITDA margins of 25.7% in the current year this appears a reasonable standalone deal. If we assume a post-tax WACC of 10%, consistent with our DCF valuation of Medserv, then METS needs to produce a NOPAT of €3.9m to create value. Even using the full EV of €39.1m, with tax likely to be around 20% we suspect METS should create value by FY18 as it expands geographically, given FY16 forecast EBITDA of €4.2m annualised and potential recovery in profitability in Iraq.

Given the strategic enhancement the deal also offers, we feel that the rationale for the deal is robust, which given the pressure on Medserv’s ongoing activities takes on added significance.

Following the sharp decline in crude oil prices, the oil majors have unsurprisingly curtailed their investment in upstream E&P activities. In addition, the pressure on financial performance has led them to seek price concessions from suppliers, especially those who had benefited from the extremely buoyant market conditions in recent years.

This has led to a sharp curtailment in activity in the Mediterranean basin with only one rig currently indicated by OPEC to be in use offshore Libya.

The oil price has been recovering to a degree and has been closing in on $50 a barrel since the continued supply and demand imbalances continue. However, there is a considerable uncertainty as to whether the rally of prices in 2016 can be maintained, or whether oversupply and other negative fundamentals will reassert themselves as the year progresses.

On a positive perspective, the areas where Medserv operates have some of the lowest extraction costs, with more resilient levels of operating expenditures. In addition, Medserv has worked with its customers to obtain cost efficiencies. This has enabled it to establish its position as a trusted services partner for the IOCs, and also to push back to a degree against the industry-wide pricing pressure.

Despite the adverse macro environment, there appears to be potential positive immediate prospects for the enlarged Medserv. While the prospects for organic growth at the Malta base appear relatively constrained due to its maturity and continued high utilisation levels following the recent influx of activity relating to Libya, there are several opportunities for the group to expand its revenue base. The company is actively seeking opportunities in several new geographies, as well as extension and expansion of existing operations.

Historically, Libya has played a significant part in Medserv’s performance. However, the fact that customers operating in the Libyan offshore oilfields are a major revenue source for Medserv means there is significant risk attached to the politics of the country. Of course, if the political situation can be resolved, then the potential for positive developments in a more unified Libya is great, including potential onshore opportunities for METS.

As conditions deteriorated onshore Libya in 2013 and 2014, many customers, and indeed Medserv itself, decided for security reasons to withdraw from onshore support operations and to instead re-establish support for offshore Libyan operations in Malta. This has been reflected in the sizeable increase in the revenues at MOL’s Malta base, which included considerable gains of business for the region due to the lack of suitable economic alternatives.

The instability in the region was highlighted in early May 2016 by a stand-off that developed with a rival NOC that had declared itself in the eastern provinces of Libya where much of the onshore production and refining capacity is based. Since late April, cargoes from the Hariga oil terminal that services the local refineries for the internationally recognised Tripoli based NOC were blocked. This was in response to the UN blacklisting of an attempted oil sale by the eastern NOC.

While it is not directly affecting the offshore projects and involvement of ENI in the West Libyan Gas Shelf Project, the dispute has the potential to choke Libya’s national financing, which depends on oil production and exports. Output had been running at only 25% of the levels seen before the removal of Colonel Gaddafi’s regime. With oil storage facilities nearing capacity there was a significant reduction in output from the fields until an agreement was reached and exports recommenced.

Although apparently resolved, investors in Medserv should be aware of the potential for upset to overall government spending levels in Libya that similar situations may cause, including offshore projects. Of course, if the overall political situation can be stabilised, then the potential for ongoing positive development in a more unified Libya is great.

Although no longer an obligation, Medserv has announced that it will continue to issue interim trading reports. Medserv released its latest interim trading report on 18 May, which contained several key comments:

While the statement reflects the continuing macro pressures in upstream E&P markets, the company also highlighted significant new contracts that should sustain healthy service volumes. Two contracts have been won with respect to the replacement of the Bouri field FPSO (Floating Production Storage and Offloading) facility offshore Libya with the contractor STX of Korea, and several other contracts are in the final stages of negotiation. Exploratory drilling is expected to recommence offshore Libya in July.

A bid has also been submitted to support a second IOC drilling operation in Cyprus. The IOC intends to use the Port of Limassol as its support base. A new round of bidding for exploration licences has also been initiated by the government of Cyprus.

The expansion into new territories also continues with Medserv responding to an international tender for the provision of a supply base in Trinidad & Tobago for another major. It has also won a contract to support drilling activities offshore Portugal, which should commence in H216. Medserv is also exploring avenues to provide services in both Egypt and Iran.

The information above was reflected in the forecast for 2016 that has been issued by the company’s brokers, Rizzo Farrugia in Malta, in line with Malta Stock Exchange Requirements. Two forecasts are released in line with requirements for the 2013 loan note issue; one for the issuer (Medserv plc) and one for the guarantor of the notes (MOL).

The guarantor forecast provides detail of the resilience of the Malta base operations, with revenues falling by 15.8% to €22.4m (€26.6m), with gross margins declining to 28.5% (30.4%).

The main elements of the Issuer overall group forecast for Medserv are shown in the table below.

The majority stakeholders in Medserv retain executive roles within the group. Anthony Duncan (via Malampaya Investments) and Anthony Diacono respectively control 33.5% and 31.4% of the issued share capital following the recent rights issue. Effectively in combination they fill the chairman and CEO roles in the company, with support on operations coming from the chief operating officer, Godwin Borg, and the chief financial officer, Karl Bartolo. It is our understanding that a formal CEO position is being created, which may mean the two principals start to relinquish some of their executive responsibilities. More information on the management is available in the bios on page 16.

We have developed a longer-term model for our assessment and use as a base case that the oil market conditions stabilise, with moderate growth returning to some of the operational regions that are currently being worst affected by political events (Libya and Iraq).

An upside case against this can be made as Medserv has the potential to develop new territories both for its offshore services operations as well as the OCTG services offered by METS. The potential for more offshore work in Cyprus, Portugal, Trinidad & Tobago and Egypt, as well as a new base for METS in Iran could enhance the valuation significantly. Downside would come in the form of significant deteriorations of MOL’s operations in Malta and a more limited impact for valuation from the METS activities in Iraq.

We have employed a capped DCF, which encompasses a six-year forecast projection from our model with a zero growth scenario anticipated in our terminal value. We have used a cost of equity of 10%, which gives us a calculated WACC of 8.1%. We have assumed the other income from the solar farm provides an 18-year term annuity at WACC. Our core assumption returns a value of €1.83 per share. A sensitivity analysis against our core assumption and the WACC and terminal growth rate is provided in the table below, with €1.84 highlighted as the closest variable to our calculation.

We believe we have utilised a relatively conservative equity risk premium for a Maltese stock, by applying a premium to suggested country rates for Malta in academic studies of around 7.5%.

Establishing a peer group is quite difficult as Medserv is unique in its location and service offering. In addition, most directly comparable companies in Europe operate in the North Sea where investment is being savaged by the lower oil price. A number have been forced into loss situations which currently limits meaningful data availability. So, we have instead chosen a number of differentiated oil services majors.

The average FY17 EV/EBITDA multiple is currently 9.9x, which if we applied this to Medserv would suggest a current fair value of €1.86. When we compare Medserv’s EV/sales against EBITDA margin it also looks slightly undervalued compared to some US majors, but pretty much aligned with profitable European companies.

Our model closely reflects the assumptions and outcomes contained in the company forecast for FY16 as outlined on Page 11. We expect uplift in revenues in 2017 from four main sources; a full year contribution from METS, a recovery in METS sales in Iraq with significant growth in Oman, a recovery in drilling activity by ENI in Cyprus and a recovery in Libyan offshore drilling activity from H216. This will be partially offset by a currently anticipated cessation of the Portugal drilling operations, which are likely to begin and largely complete in H216 at least initially, as well as ongoing pricing pressure from customers. Any change to these assumptions will impact our forecasts accordingly.

We do not anticipate any contributions from the numerous additional geographic expansion opportunities the company is pursuing.

The outlook for Medserv remains challenging although activity levels remain high. We expect FY17 gross margins to continue to remain resilient, and indeed be slightly enhanced by the full year contribution from METS, where we anticipate some improvement in contribution from both the UAE and Iraqi operations.

To finance the METS acquisition the company launched a rights issue process in December 2015 alongside a bond issue.

The rights issue was launched on the basis of two new shares for every nine held at an offer price of €1.50. In the rights issue neither Mr Diacono nor Malampaya Investments, the two major shareholders (37.5% each of the 31 December 2015 shares in issue) subscribed fully, instead via a placing the vast majority of their entitlements Malampaya subscribed for 30% of its entitlement and Mr Diacono none.

Of the 2.5m shares offered to other existing shareholders, 2.0m (80%) were taken up in the initial rights period. The balance together with outstanding new shares following the intermediary placing of majority shareholders rights were then offered to the general public via a lapsed rights offer. Of the 3.52m so offered 1,255,650 shares remained unsubscribed and were not issued. In aggregate 8,744,399 were issued, raising c €12.5m net of costs. With the completion of the rights Mr Diacono’s shareholding has fallen to 31.4% and Malampaya Investments’ has dropped to 33.5%. The free float has thus increased from 25.0% of the issued capital to 35.1%.

The ex-rights adjustment factor on the rights issue is 0.9768, so we have adjusted all historical earnings and dividends by this amount to reflect the bonus issue element of the rights.

The company offered an aggregate €30m in bonds in two denominations: euro and US dollar. These were attached to acceptance of the equity rights and resulted in an oversubscription of $9.7m and €35.2m. The $9.15m of dollar bonds carrying a coupon of 5.75% were fully allotted and the Eurobonds with 4.5% coupon were scaled back to 76.26% of subscriptions, for the nominal amount of €21.98m.

As a result of the rights and bond issues, Medserv raised c €7m more than was required for the METS purchase. Some of the surplus was used to eliminate the company’s overdraft facilities, but management is forecasting gross cash balances at the year-end of €9.6m.

What is clear is that the acquisition combined with the softer trading conditions has put an unintended strain on the financial metrics. Net debt to EBITDA is forecast to be 3.94x at the end of 2016, and EBITDA interest cover is 4.0x. We expect both metrics to improve significantly in 2017.

While as far as we can ascertain there are no direct bond covenants on either the 2023 6% loan notes or the 2026 dollar and euro denominated bonds, there are some covenants on the banking facilities. On our base forecast, the company should retain healthy free cash flow, with added stability from the METS operations and we do not believe these are likely to be breached. Clearly, replicating the model in new territories could further increase the scope for organic development of profits and cash generation as Medserv expands its geographic presence.

Capital allocation nevertheless remains an important factor over the next few years. We would expect management to prioritise spending in the following order: organic investment, debt management, dividend and additional M&A.

The company’s stated distribution policy is to distribute 40% of future earnings generated subject to adequate cash flows, profitability and distributable reserves. Historically accumulated distributable reserves were paid to shareholders last year via an exceptionally high pay-out ratio in advance of the introduction of new shareholders via the rights issue. At present, we expect management to adhere to this policy.

Malta is an attractive tax regime. There is no capital gains tax for bonds or equities, and the dividends from MOL are essentially tax free to Medserv due to the investment credits totalling €6.3m. In addition, both METS and Medserv enjoy preferential corporate tax rates resulting from their operation in free trade zones.