O&M sector remains underweight — We recently met with investors in Europe and sense clients are much more cautious on the sector as compared to Asian based investors. Most remain underweight on the sector. The concerns are the duration of the current rig building downturn, and whether orderbook wins can resume. Investors opined the sector will de-rate further and want to see evidence of orderbook returning first to the sector before considering the investment merits.

Our key arguments — i) contrary to investors' perception, the rig supply response during recent cycle is far more muted than thought ii) orderbook will be a lagging indicator during a recovery phase, iii) do not ignore strength of the FPSO market rebounding in 2010 onwards iv) unless Petrobras is willing to compromise on its E&P ambitions, KEP/SMM appear best positioned to capitalise.

Margin direction — Questions were also raised as to whether recent O&M margin strength could be repeated in 2010 given further productivity gains and repeated deliveries. We believe this is possible since other cost items like raw materials are already locked in. However, deliveries from 2012 onwards (via new orderbook) should see margin diluting back to 2006-07 levels given the competitive landscape, but not a sharp margin collapse as some may fear.

Financing, not rig supply is a bigger threat — Our earlier concerns on funding risks have now turned consensus. We reiterate the credit crunch, not rig supply remains a bigger threat to rig building orderbook since funding source for both ship and rig building emerge from similar group of European banks. Although credit spreads have narrowed, counter party risks have yet to abate and (eg. collapse in ships collateral values) have negative implications for rig financing.

Valuation — Investors were surprised the sector is not trading above its historical average mean after sharp YTD rally. Although both KEP/SMM has outperformed STI, both stocks, particularly Keppel O&M is trading below the recent cycle P/B average. We highlight potential upside surprise to our EPS forecasts on further margin accretion, and orderbook returning could be re-rating catalysts.

Other stocks in focus; ST Eng — Investors are divided on ST Eng. Some opined 2010 consensus forecast remains conservative considering the strength of the recent margin recovery for the MRO business, continued strength in Electronics and M&A catalysts. However, others are concerned on prospects of orderbook wins and believe a DPS cut is highly likely.