Examining Offshore Drillers: Buy, Sell Or Hold (Part 1)

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Includes: IEZ, NE, OIH, PXJ, RIG, SDRL
by: Dan Strack

Offshore drillers have been underperforming the market as a whole over the past year and have ran into a brick wall over the past week due to reported weakness in contract renewal in early 2014 by Noble Corp. (NYSE:NE) in their quarterly earnings call. Many analysts also believe the market is trying to digest the glut of new builds that will be entering the market over the next 2 years and as a result day rates could drop. The purpose of this article will be to examine the major companies in the industry and determine how they stack up against each other and whether they are attractive buys at current prices.

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Industry Comparison

Part I will cover Transocean (NYSE:RIG), Seadrill (NYSE:SDRL) and Noble Corp. Part II will cover Ensco (NYSE:ESV), Diamond Offshore (NYSE:DO), Rowan Companies (NYSE:RDC) and Atwood Oceanics (NYSE:ATW). All of these companies have experienced weakness over the past couple months and particular weakness over the past week. These companies are all at different points in their growth patterns. While some offer significant growth potential, others have impressive dividend yields and others are trading at attractive values.

Transocean

Seadrill

Noble Corp.

Ensco

Rowan

Atwood

Diamond

Peer Average

Share Price (1/30/14)

$ 43.41

$ 36.40

$ 31.56

$ 50.26

$ 31.36

$ 46.72

$ 48.78

N/A

Revenue per share (TTM)

$ 26.29

$ 10.06

$ 16.28

$ 20.60

$ 12.48

$ 15.64

$ 20.86

$ 17.46

Market Cap ($mil)

$ 16,080

$ 17,360

$ 8,150

$ 11,920

$ 4,030

$ 3,060

$ 7,040

$ 9,663

Forward P/E (12/31/14)

8.4

10.31

7.73

7.62

10.22

7.94

7.5

8.53

Price/Book

1.0

2.48

1.02

0.96

0.85

1.41

1.53

1.32

Profit Margin

17.2%

50.8%

19.0%

26.8%

16.7%

34.4%

23.9%

27.0%

Total Cash ($mil)

$ 3,560

$ 867

$ 114

$ 325

$ 1,010

$ 88

$ 1,220

$ 1,026

Total Debt ($mil)

$ 10,730

$ 13,930

$ 5,560

$ 4,790

$ 2,010

$ 1,270

$ 1,500

$ 5,684

Debt/Equity ratio

0.65

1.79

0.61

0.38

0.42

0.57

0.32

0.68

Current Ratio

1.95

0.45

1.32

1.61

5.74

2.89

4.31

2.61

Yield

5.1%

10.1%

3.0%

5.8%

0.0%

0.0%

1.0%

3.6%

Diluted EPS

4.49

4.95

3.05

5.46

1.61

5.32

5.00

4.27

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Source: Yahoo Financials

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Source: Transocean Investor Day (11/21/13)

Transocean

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This Switzerland based offshore drilling company has the largest fleet in the world with 80 rigs and 12 more under construction. The company has slowly been trying to claw its way back after its rig was used by BP during the Deepwater Horizon spill in 2010. This incident has been like a dark cloud hovering over the company. In early 2013, the company was fined $1.4 billion for violations of the Clean Water Act which is payable over the next 5 years. Transocean also continues to face uncertainty from future claims arising from this incident.

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Source: Transocean Investors Day

The company has a massive backlog totaling $29.8 billion as of 9/30/13 with $8.2 billion in guaranteed contracts in 2014. Of the 12 new rigs being built, 7 have contracts in place with 2 of those being delivered in Q2 2014. In 2014, the company will see 23 rig contract extensions go into effect with an average day rate increase of roughly $33,000. There are also 19 rigs whose contracts are set to expire in 2014 without a contract extension in place. While many of these rigs will likely get a new contract in place, it is of concern since there are already reports of contract weakness in early 2014.

Nine months ended 9/30/13

2013

2012

Y/Y % change

Revenue($mil)

$ 7,152

$ 6,870

4.1%

Expenses

$ 5,304

$ 5,730

-7.4%

Operating Income

$ 1,817

$ 1,040

74.7%

Net Income

$ 1,174

$ (675)

273.9%

EPS

$ 3.23

$ (1.90)

270.0%

Cash

$ 3,559

$ 5,134

-30.7%

Long-term debt

$ 10,388

$ 10,929

-5.0%

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Transocean has returned to profitability in 2013 and is set-up for a strong 2014 as well. As a result of this turnaround and clear visibility in future business with the nearly $30 billion backlog, the company increased its dividend in mid-2013 to $2.24/share. This translates into a dividend yield of 5%. In 2014, there is a proposed 34% dividend increase to $3.00/share. The company is also pursuing an aggressive cost savings program which they expect to trim $800 million from total expenses by 2015.

In early 2013, Carl Icahn took a 5.6% stake in the company and has pressed management to return value to shareholders. After successfully convincing the board of directors to increase dividends, he successfully lobbied the company for the creation of a master limited partnership, which will provide the company with financial flexibility. The spin-off should happen sometime in mid-2014 and will allow the company to sell certain assets to the MLP and improve the company's balance sheet.

Recommendation: BUY. At under $44/share the company is trading at attractive levels for the long-term investor and will increase its dividend by 34% in 2014 for a yield over 6%. With debt at manageable levels and the Deepwater Horizon spill in the rearview mirror, risks are at acceptable levels.

Seadrill

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With a dividend yield over 10% and debt through the roof, Seadrill is the most difficult offshore driller to analyze and by far the most debated. Seadrill is the largest offshore driller by market cap but 4th largest based on total number of rigs. Seadrill focuses on ultra-deep water drillships and is second, only behind Transocean, with 32 UDW rigs. Having taken on an extremely aggressive new build program, the company boasts one of the youngest fleets in the industry and is focusing on premium assets.

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Source: Seadrill SEB Nordic Presentation

Seadrill has 21 rigs under construction with 2 completed in late 2013 and delivered in early 2014. Seven rigs are scheduled to be completed in 2014 but only one of those has a contract in place. Of the 11 rigs scheduled to be completed in 2015, only 1 has a contract. In total only 3 of the 21 rigs under construction have long-term contracts. While there's still time for Seadrill to establish contracts for its new builds, its concerning that such a large glut of rigs are coming online in the next 2 years with no contracts in place. Seadrill has taken on aggressive debt financing on the assumption that attractive long-term contracts will be in place. Management has predicted strong demand based on market demand for 20-30 new units per year and the ability for the industry to only deliver 20-25 rigs per year. However, the company has acknowledged the market has slowed down since 2012 as companies re-evaluate spending plans.

Nine months ended 9/30/13

2013

2012

Y/Y % change

Revenue($mil)

$ 3,528

$ 3,168

11.4%

Expenses

$ 2,344

$ 1,913

22.5%

Operating Income

$ 1,530

$1,351

13.2%

Net Income

$ 2,505

$1,207

107.5%

EPS

$ 4.98

$ 2.37

110.1%

Cash

$ 551

$ 318

73.3%

Long-term debt

$10,087

$ 8,695

16.0%

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The 800 lbs gorilla in the room whenever discussing Seadrill is the debt load. Seadrill has far more debt and less liquidity than any other company in the industry. Another Seeking Alpha contributor, Power Hedge, has a very good article discussing the debt structure and how the company manages it. While the company does have outstanding bonds, the majority of the debt stems from several bank loans and credit facilities. Many supporters of Seadrill argue that while there debt is high (over $12 billion in interest bearing debt), the company has flexibility due to these credit facilities and they have the revenue growth to support such a high debt load.

Source: Seadrill Q3 2013 report

The bottom line for me is the 18 rigs under construction that don't have contracts and its debt ratio and leverage is significantly higher when compared to industry peers. The company is relying on strong contracts from its rigs under construction to support the company's aggressive strategy and short term weakness in new contracts that Noble Corp. commented on could potentially magnify downside movement since it is so highly leveraged.

Recommendation: HOLD Seadrill is down approximately 25% since September so it is starting to look cheap, but any continued weakness in the industry will affect Seadrill far more than its peers. With a dividend yield over 10%, it's hard to sell a stock that returns so much value to shareholders. Current share holders should continue to watch for new contracts on the company's rigs under construction. If rigs start rolling off the line without contracts, it's time to sell.

Noble Corp.

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Noble Corp. started some of the industry weakness seen in the past week when they announced weakness in contracts over the first half of 2014. Following this news and a sharp decline in stock price seen above, I wrote an article pointing to the short-term weakness as a good entry point for long-term investors. Noble added 2 new rigs in Q4 2013 with an average day rate of $438,500, which helped add roughly 8% revenue growth for the quarter. In 2013, the company added 3 ultra-deep water drillships and 2 high-spec jackups. The company currently has 7 new rigs under construction and all but 2 have secured long-term contracts. The 2 without contracts are scheduled to be delivered in Q4 2014. Having successfully secured contracts for the majority of rigs under construction and the rigs delivered in 2013, the company now has a backlog of $15.4 billion.

Twelve months ended 12/31/13

2013

2012

Y/Y % change

Revenue($mil)

$ 4,070

$3,349

21.5%

Expenses

$ 3,112

$2,763

12.6%

Operating Income

$ 1,121

$ 783

43.2%

Net Income

$ 850

$ 556

52.9%

EPS

$ 3.05

$ 2.05

48.8%

Cash

$ 114

$ 282

-59.6%

Long-term debt

$ 5,556

$4,634

19.9%

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Noble Corp. has done an outstanding job of growing revenues and earnings. This growth should be further accelerated by the 6 new rigs coming online in 2014 (4 of which have contracts in place) and full operating years for the rigs that came online in 2013. During 2014, Noble has 19 rigs whose contracts are set to expire without renewals in place at an average day rate of $217,000. However, the majority of these are standard jackups that the company is set to spin-off into a new company. By the end of 2014, the company plans to spin-off its standard assets and retain its high-spec and ultra-deep water drillships. The "new" Noble will keep the new rigs and those under construction which will give it a premium fleet that will be one of the youngest in the industry.

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Source: Noble presentation

Noble Corp. had a solid 2013 with strong earnings growth projected through 2015. The company has done a good job of securing quality contracts for its new rigs delivered in 2013 and those that are set to begin operations in 2014. The short-term weakness announced in the quarterly earnings call creates a good buying opportunity.

Recommendation: Strong BUY Long-term contracts secured for the majority of the rigs Noble Corp. will retain after the spin-off puts the company in a good position going forward. A dramatic drop in stock price, which is based on short-term weakness, is the simplest way to buy a quality stock at a good entry point.

Conclusion

The offshore drilling industry has seen a sell-off over the past few months. Analysts want to see how the industry is going to react to new rigs coming online over the next year or so. However, there are companies that have already secured long-term contracts with a variety of clients. It seems the industry is starting to heavily favor high-spec rigs and UDW drillships, so the companies with these assets in place should do very well going forward. New deepwater discoveries will continue to create opportunities in Mexico, Brazil and off the coast of West Africa.

Part II of my analysis will be available next week and will focus on Ensco, Diamond Offshore, Atwood and Rowan.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.