Vantage Drilling: Why The Shorts In This $1 Stock Bargain Are Likely To Get Burned

| About: Vantage Drilling (VTG)


Shares of Vantage Drilling are trading at bargain levels due to misplaced concerns.

Shorts are likely to get burned in a short-covering rally, as it won't take much good news for this stock to take out the 52-week high of just $2.06.

With revenues surging and the company solidly profitable, the potential upside has probably never been better.

Insiders hold large stakes in Vantage Drilling as does Fidelity Investments (around 42 million shares) which shows a lot of "smart money" is seeing upside.

Analyst price targets of between $3 to $4 per share also indicate major upside, and some analysts see Vantage Drilling as a takeover target due to its modern fleet.

As a contrarian investor, I prefer to buy out of favor assets that are mis-priced and trading at bargain levels. That is what led me to write an article and buy Petrobras (NYSE:PBR) for about $10 per share recently. Since that article was published on March 19, 2014, Petrobras has jumped by about 40%. In that article, I described how misguided and overly bearish sentiment by investors and shorts created a fantastic buying opportunity in Petrobras. While it is tougher to find bargains in this market, there is another stock in the oil sector which I believe could rise even more than Petrobras this year. That stock is Vantage Drilling (NYSEMKT:VTG) which currently trades for about $1.67 per share.

Vantage Drilling has a highly experienced management team and a modern offshore drilling fleet. The company went public in 2007 at about $8 per share and experienced major challenges with the financial crisis that started in 2008, only to be hit again by the oil spill in the Gulf of Mexico in 2010. However, it has managed these challenges and it is now posting profits. Vantage Drilling recently earned 9 cents per share for the fourth quarter of 2013, and it is expected to post strong revenues and profit growth in the coming years thanks to major new contracts. Analysts expect the company to earn 31 cents per share in 2014 and 35 cents per share in 2015. With the stock at about $1.67 per share it now trades at a bargain level of just over 4 times earnings. For the stock to be this cheap, something must be up, and you would be right to think so. However, I think the issue overhanging this stock is nothing but a paper tiger.

There are three issues that are creating what I believe is a temporary "overhang" on this stock. Let's take a look at these three issues and review why these are nothing more than "paper tigers" that are giving investors a chance to be cheap. I expect all these factors to be positively resolved for Vantage Drilling and its shareholders in the long-run:

1) One potential downside risk is the debt on the balance sheet of about $2.92 billion. That is a lot of debt for a company with around $55 million in cash. This debt load appears to have weighed on the stock for the past few years, but the debt could turn out to be a positive in the next few years because of the leverage it provides. As most investors know, leverage can be a negative in a declining economy, but it can also greatly amplify returns in an upturn and that seems to be where the global economy, and Vantage Drilling are heading. If this company was able to successfully manage this debt load during far more challenging economic times and with less revenue, the idea that it is now likely have trouble paying debt seems deeply misguided. Furthermore, as announced in the financial results for the fourth quarter, the company plans to begin paying down debt.

2) The shorts have been camped out in this stock for years and that has put significant pressure on these shares. However, with Vantage Drilling now posting solid profits and major revenue growth, some shorts are starting to cover. According to data from there are about 14.9 million shares that are currently short. With average trading volume of about 1.7 million shares per day, the short interest is equivalent to roughly 9 days worth of trading or just over 8% of the float. This is more than enough to create a potential short-covering rally, or even a more significant short-squeeze. Some shorts are possibly starting to see the potential risks because about 500,000 shares have been covered by shorts since the last data was reported. If this trend continues or accelerates, the stock could benefit significantly.

3) Vantage Drilling has filed a lawsuit against one of its former directors and one of its largest shareholders, Hsin-Chi Su, who had significant dealings with Vantage Drilling in the past. Vantage Drilling is claiming breach of fiduciary duty, fraud and other torts against Mr. Su. It appears that this former director still owns tens of millions of shares (either directly or through entities he controls). Some investors and shorts appear to believe that Mr. Su could be in a financial jam and this has caused concerns about a large amount of shares being sold by Mr. Su or potential creditors. This appears to be causing a real overhang on the stock, but it also looks like this concern is greatly exaggerated for a number of reasons. First of all, at current (bargain) levels, the stock already appears to have priced in this issue. Secondly, the idea that tens of millions of shares would suddenly be dumped onto the market with great haste is perhaps nothing more than a short sellers dream. If you consider the facts and probabilities, this "dream" for shorts is extremely unlikely. For example, if Mr. Su's shares were pledged to a bank or a bankruptcy trustee, there is almost no chance the shares would be suddenly dumped on the market and therefore cause the stock to be pressured. That is because a bank would have a fiduciary duty to its shareholders, to get the highest possible price for the stock. That means the chance of a big block of stock being dumped in the open market is probably not in the cards. A bankruptcy trustee also has fiduciary duties to creditors to get the highest price for any asset, so for the same reasons, we are just not likely to see the selling pressure the shorts are hoping for.

If there is a situation whereby Vantage Drilling was able to either "cancel" those shares in a settlement or win a judgment against Mr. Su, this could be a great development for shareholders. However, even if the company does not win a judgment or settlement and even if the shares are transferred to another creditor, those shares are just not likely to be sold in any sudden manner in the open market, for the reasons described above. If a large block of shares were made available, there is a good chance that Vantage Drilling or a major institutional investor would be the potential buyer. In an effort to shed light on this issue, I did call investor relations at Vantage Drilling and confirmed on this call that the company has a note payable for about $60 million to Mr. Su (and/or his entities) which is due in 2017. That puts the company in a strong position to compel a settlement in this matter (or withhold payment). I believe that investors and shorts who are focused on this "overhang" are missing the big picture as this issue is truly a sideshow. The reality is that no matter what happens with this legal dispute, it has nothing to do with the long-term fundamentals of Vantage Drilling or the growth in this industry. I believe that Vantage Drilling shares will rise significantly even if some shares were to be sold by a bank or bankruptcy trustee, because there will be nothing left for investors to fear. No matter what happens, clarity on this issue is likely to be the enemy of shorts who have used this situation to scare off investors with rumors and highly unlikely worst-case scenario fears which have been posted on stock message boards.

Vantage Drilling will clear up this issue sooner or later and what investors are left with is a company that is posting strong revenue and profit growth. This company also has a modern fleet that is able to command some of the highest day rates in the industry. This also makes the company a potential takeover target since companies like Transocean (NYSE:RIG) need to modernize and refresh its fleet. Some industry watchers and analysts believe Transocean could be a likely suitor for Vantage Drilling, which is one more reason shorts could be very wrong about this stock. In one article, an analyst suggests that if Transocean were to buy Vantage Drilling, it could boost Transocean's earnings by about 10%.

It's also worth noting that the CEO of Vantage Drilling, Paul Bragg, owns nearly 6 million shares and a number of other insiders also have multi-million share positions. FMR LLC., (which is the mutual fund giant known as Fidelity) owns nearly 42 million shares, which is almost 15% of the entire company. This is another reason why I believe shorts are naive if they don't see how easily an institutional investment company like Fidelity or Vanguard could buy any large blocks of shares. (If it ever even came to that.)

In summary, Vantage Drilling shares offer tremendous value as some investors and shorts mistakenly believe there will be a better buying opportunity in a large block sale. When looking at the most realistic probabilities, this is extremely unlikely to occur for the reasons explained above. When there is clarity on this issue, the stock is likely to surge and burn shorts with their seemingly false hopes. Finally, when you see insiders like the CEO and mutual fund giants such as Fidelity buying and holding over 40 million shares, I would bet that they too, know that this share and litigation issue is a sideshow. This issue is a temporary paper tiger that has nothing to do with the business fundamentals or the longer-term upside potential of the stock. Analysts are bullish on Vantage Drilling shares and also appear to see through this "paper tiger" issue: RBC Capital Markets initiated coverage on Vantage Drilling with an outperform rating and set a $3 price target. Analysts at Wunderlich initiated coverage with a buy rating and set a $4 price target. On December 9, 2013, an article stated that selected Vantage Drilling as a top pick for 2014. Just as I thought with Petrobras, I believe contrarian and value investors have a terrific buying opportunity with Vantage Drilling.

Here are some key points for Vantage Drilling:

  • Current share price: $1.66
  • The 52 week range is $1.57 to $2.06
  • Earnings estimates for fiscal year 2014: 31 cents per share
  • Earnings estimates for fiscal year 2015: 35 cents per share
  • Annual dividend: n/a

Data is sourced from Yahoo Finance. No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.

Disclosure: I am long PBR, RIG, VTG. 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.