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Morningstar | Adjusting Saipem and Subsea 7 FVEs on Revised View on Offshore E&C Market Positioning

We are slightly adjusting our fair value estimates for Saipem and Subsea 7, after reconsidering our forecasts for the relative performance for both in the offshore engineering and construction market (which accounts for about 60% and 100% of each company's operating income, respectively). We've increased our long-term operating margin forecast for Saipem's Offshore E&C segment by about 50 basis points, but lowered our margin forecast for Subsea 7 by about 50 basis points. As a result, our Saipem fair value estimate moves up to EUR 4 per share from EUR 3.75 previously, and conversely our Subsea 7 fair value estimate moves down to NOK 123 from NOK 127 previously. Our no-moat ratings for both companies remain unchanged.

The two companies have experienced highly divergent outcomes in their offshore E&C businesses over the past two years. Based on current company guidance and our forecasts, we expect Saipem's 2019 Offshore E&C segment revenue will have grown 10% cumulatively vs. 2017, whereas Subsea 7's total company revenue will be down about 1%. Also, Saipem looks set to post a Offshore E&C adjusted operating margin of about 7% in 2019, only down modestly from about 10% in 2017. Meanwhile, Subsea 7's operating margin will fall to about 4% vs. 15% in 2017. Saipem's improvement in Offshore E&C profitability has been very impressive--we even think it will lead peers in 2019 (besting even TechnipFMC--which competes via its Subsea segment).

Saipem has managed this turnaround in relative performance by first winning a large share of awards, including Eni's Zohr in Egypt and the first two phases of Exxon's Liza in Guyana. This has aided profitability due to operating leverage, but importantly it appears that Saipem hasn't bought market share due to overly low pricing. Furthermore, management has credited the impact of very strong project execution, marking a stark contrast to the 2013 to 2016 period when bad execution generated large segment losses.

Meanwhile, Subsea 7's margin performance has been disappointing, especially given that its still benefiting from legacy high-margin day-rate contracts with Petrobras, which we estimate are boosting the company's margins by 100 basis points relative to if the contracts were at current market rates. Management has only called out industry pricing headwinds as a cause for weaker margins, but clearly this hasn't kept peer Saipem from maintaining more resilient margins.

Still, we don't feel the evidence of recent results is sufficient to totally reverse our long-term thesis that Saipem will be last behind Subsea 7 and TechnipFMC in the industry pecking order. Our long-term operating margin forecast is about 14% for TechnipFMC's subsea E&C business, 10.75% for Subsea 7, and 9.5% for Saipem's Offshore E&C segment.

For one, we think some of Saipem's recent margin strength could be due to overly conservative contract accounting as a response to poor execution in the company's history--for contracts finishing in 2018, conservative accounting would have depressed margins in 2017 but boosted margins in 2018. In the first-quarter 2019 conference call, management alluded to this having a positive effect in recent quarters.

More importantly, Saipem's very weak relative performance over the long run should not be forgotten. Over the 2009 to 2018 period, average operating margins for the three main offshore E&C players were 14.5% for TechnipFMC, 14% for Subsea 7, and 9% for Saipem. Furthermore, we think Saipem is lagging on the industry trend toward integrated projects.