Rowan Companies: Prices To Jack Up

| About: Rowan Companies (RDC)

Summary

Rowan Companies is a very well regarded shallow water jack-up drilling rig offshore operator, which has recently entered the ultra-deepwater segment with 4 newbuild drillships.

I expect that there will be substantial earnings growth from Rowan Renaissance, Rowan Resolute, Rowan Reliance & Rowan Relentless, all drillships entering the fleet during 2014 and 2015.

I expect visible growth will translate to price gains as conviction in earnings growth rises as operations commence during Q2 2014.

High earnings growth will drive long-term returns. A near-term return catalyst includes visibility adding conviction to expectations as Renaissance starts operations during Q2 2014.

I am very bullish on the offshore drilling companies over the coming three to five year horizon. I did an article about Transocean (NYSE:RIG), which I feel can triple over three to five years. If you run through the comments on the Transocean article, you can see why I expect similar returns for Ensco (NYSE:ESV). I like Diamond Offshore (NYSE:DO) too for reasons set out in another recent article about offshore drillers. Seadrill (NYSE:SDRL) also has high return potential and superb fleet quality. The beauty of these four companies is the generous dividend yields on offer. And healthy backlogs suggest that these yields are sustainable for the foreseeable future.

And then there is the fifth. Rowan (NYSE:RDC), with a market capitalization of just over $4 billion, is best described as a mid-cap offshore driller, with a formidable reputation in the shallow water jack-up market. Unfortunately, they don't pay a dividend, so that salve to help sustain us through the indignities of price declines is absent. But long-term earnings growth expectations as reported on Reuters at 23.56%, is the highest amongst the group of five offshore drillers which I have looked at. And the estimates for 2015 look light based on the new ultra-deepwater assets in service and coming into service over the coming two years.

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Source: Data from Reuters Quotes for the companies - Financials tab, together with my analysis.

Rowan has a fleet of 30 jack-up type drilling rigs, of which 19 are classified as high specification. But what is often overlooked is their recent entry into the ultra-deepwater segment. Rowan recently took delivery of Rowan Renaissance in January 2014. Rowan Renaissance is capable of drilling in water depths of 12,000 feet and able to drill to depths of 40,000 feet below the seabed. This rig starts work on a three-year contract with Repsol in April 2014 in West Africa at a rate of $619,000 per day. If the rig relocates to the Gulf of Mexico in the year two or three, the rate will be $614,000 for year two and $624,000 for year three. If the rig continues to operate in West Africa, the rate will rise to $644,000 and $654,000 for years two and three respectively.

Coming next is Rowan Resolute, which is scheduled for delivery in June 2014. This rig starts work for Anadarko in the Gulf of Mexico in September 2014 for a three year term at a day-rate of $608,000 per day. The rig has identical water depth and drilling depth capabilities as Rowan Renaissance.

Then comes Rowan Reliance, with identical capability as the prior two rigs, scheduled for delivery end October 2014. This rig commences operation for Cobalt in January 2015 on a three year drilling contract at a day-rate of $602,000 per day.

Last comes Rowan Relentless, also with identical capability as the prior mentioned rig, which is scheduled for delivery in late March 2015. A client is available for this rig, but the client, contract duration, operating locale and day-rate have not been disclosed in the fleet status summary which you can download here.

The big fear in the offshore drilling industry today is softness in the ultra-deepwater segment over the coming two years, after which it is expected that oil majors will ramp up drilling. In the case of Rowan, the fleet is brand new - much of the softness in day-rates will be felt in the older assets. What more, Rowan is covered during the period of anticipated market softness as they have contracts in place covering a three year term, for three of four rigs, and I suspect there will be something similar for the fourth rig.

In 2015 I am looking for earnings of $5.83, with downside risk to $4.73 and upside to $7.03. My central estimate of $5.83 is considerably higher than average Reuters consensus. It is also higher than broker estimates which Rowan publishes on its website.

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Source: Rowan Companies website.

In my view consensus estimates are too low given that four new ultra-deepwater assets with very healthy day-rates will be operational during 2015.

With Rowan's U.K. structure, the effective tax rate should run at or below 20%. And with the day-rates of over $600,000, as has been agreed with customers, based on typical operation costs and revenue efficiency for the newer ultra-deepwater rigs, these assets can be expected to generate at least $3.30 in incremental earnings per share.

The $3.30 potential earnings from the new deepwater assets would not change materially if drilling cycle conditions change. But if the down-cycle continues through 2015, the earnings from the remainder of the fleet is expected to be $1.53, for a total of $4.73 in downside earnings expectations. This estimate is based on Rowan's historic operational performance during down-cycle conditions. This is a conservative estimate and excludes the impact from tax savings which arise as a result of Rowan Companies recent (2012) adoption of U.K. as its domicile.

If we find ourselves in mid-cycle conditions, earnings from the residual fleet can be expected to deliver $2.53 per share, taking expected earnings to $5.83. This estimate is based on Rowan's historic operational performance over the course of a typical drilling cycle. This is also a conservative estimate and excludes the impact from tax savings which arise as a result of Rowan Companies' recent (2012) adoption of U.K. as its domicile.

If we find ourselves in up-cycle conditions, we can expect to see earnings per share from the residual fleet at $4.03, taking upside earnings expectations to $7.03. This estimate is based on Rowan's historic operational performance during up-cycle conditions. This is a conservative estimate and excludes the impact from tax savings which arise as a result of Rowan Companies recent (2012) adoption of U.K. as its domicile.

Working with a multiple of 15, a 20% discount to the present market multiple, I arrive at a price target of $71 for down-cycle conditions and $105 for up-cycle conditions and $87 as a reasonable price expectation over the course of a drilling cycle. The stock recently traded at $32.83, thus we have a two year annualized return potential of 48% to 79%. If despair in the drilling cycle lifts a year later (2016), the annualized three year return potential falls to 29% to 47%. In my view, sizeable short-term (6 to 12 month) gains of approximately 50% are possible if we do see positive earnings surprises in Q2 2014 as I expect.

As you will see on the first table in this article, from amongst the five offshore drillers for which data is presented, Rowan trades at the lowest multiple of 2015 earnings expectations. There is scope for gains through expansion of the multiple and upward revision of earnings. It is likely that both will occur together.

Conviction in earnings growth builds with performance and earnings surprises. Rowan Renaissance will start work in April 2014. And as the second quarter rolls by, I hope to see the earnings potential of the new assets demonstrated. Once clear visibility of the ultra-deepwater earnings potential is displayed, earnings estimates should start rising instead of declining. And as conviction builds, we should see multiples expand.

Disclosure: I am long RIG and may initiate a long position in RDC 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.