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Summary

  • The offshore drilling industry remains depressed creating attractive entry points for long-term investors.
  • Investors looking for downside protection, earnings growth and dividend yield can find several candidates among the offshore drillers.
  • While there is uncertainty in the short-term, the long-term fundamentals in the industry remain strong.

In the final part of my analysis of the offshore drillers, this article will cover Seadrill (NYSE:SDRL), Rowan Companies (NYSE:RDC), Pacific Drilling (NYSE:PACD) and Hercules Offshore (NASDAQ:HERO). This is the third and final article I will present this quarter on the offshore drilling industry.

Part 1: Noble Corp (NYSE:NE), Ensco (NYSE:ESV)

Part 2: Transocean (NYSE:RIG), Diamond Offshore (NYSE:DO), Atwood Oceanics (NYSE:ATW)

Part 3: Seadrill, Rowan Companies, Pacific Drilling, Hercules Offshore

Transocean

Seadrill

Noble Corp.

Ensco

Rowan

Atwood

Diamond

Hercules Offshore

Pacific Drilling

Peer Average

Share Price (6/6/14)

$42.63

$39.38

$31.34

$51.94

$30.70

$50.33

$47.20

$4.52

$10.19

N/A

Revenue per share (TTM)

$26.34

$10.53

$17.31

$21.45

$12.79

$16.70

$20.37

$5.81

$3.44

$17.46

Market Cap ($mil)

$15,300

$17,900

$7,800

$12,100

$3,800

$3,200

$7,000

$718

$2,200

$7,780

Enterprise Value/EBITDA

6.54

11.47

6.19

6.91

8.18

8.37

7.01

5.57

12.02

$8.03

P/E

9.9

7.1

10.1

8.3

15.5

9.2

13.9

N/A

67.8

Forward P/E

10.2

10.5

9.1

8.5

12.7

6.9

12.8

8.6

10.1

9.9

Price/Book

0.93

2.17

0.92

0.92

0.79

1.29

1.55

0.89

0.87

1.32

Profit Margin

14.80%

53.72%

20.26%

28.11%

15.99%

32.44%

18.33%

-8.97%

3.42%

27.00%

Total Cash ($mil)

$1,987

$1,160

$114

$173

$1,090

$59

$1,600

$197

$204

$1,026

Total Debt ($mil)

$10,700

$12,424

$5,730

$4,750

$2,010

$1,510

$2,490

$1,290

$2,440

$5,684

Debt/Equity ratio

0.64

1.83

0.62

0.36

0.41

0.63

0.54

1.52

1.01

0.68

Current Ratio

1.91

0.74

1.48

1.55

4.31

3.15

2.87

2.14

2.2

2.61

Yield

5.20%

10.26%

4.90%

6.00%

1.30%

0.00%

6.80%

0.00%

0.00%

3.60%

Diluted EPS

3.87

5.4

3.46

5.96

2.03

5.35

3.73

-0.53

0.12

4.27

Source: Yahoo Financials and CNBC

Industry Overview

(click to enlarge)

The offshore drilling industry has been one of the major laggards in the market over the last several months, creating attractive entry points for investors with long-term investment horizons. While near-term demand prospects remain uncertain, the long-term health of the industry remains strong. With 30 newbuilds being delivered in 2014 and an additional 19 being delivered in 2015, many analyst are concerned with an oversupply in the market resulting in lower dayrates. While some rigs have seen lower rates and competition for renewing contracts in 2014 is fierce, there are a number of companies that have avoided this mess and are positioned well to weather this short-term weakness. With strong demand being seen in the Gulf of Mexico, Brazil and West Africa, many companies have set themselves up very well to profit from this strength.

Seadrill

Seadrill turned in a mixed bag when it reported quarterly earnings on May 28. On one hand long-term debt was reduced by over $1 billion, the dividend was increased by $0.02/share, and the company benefited by the deconsolidation of Seadrill Partners. On the other hand, total operating revenue dropped year-over-year and the company announced a number of their newbuild deliveries would be delayed by up to 6 months. Looking at the numbers alone, it appears the company had a great quarter, but deep down the company struggled on the operational side, which is rare for Seadrill.

Revenue for the quarter was $1,221 million, down $44 million from 1Q2013 due to a slight decrease in total utilization to 88% and 97% for floaters and jack-ups, respectively. 1Q2014 EBITDA was $624 million, excluding gain on the sale of the West Auriga, compared to 1Q2013 EBITDA of $713 million. When taking into account the gain on the sale of the West Auriga and the gain on the deconsolidation of Seadrill Partners, 1Q2014 net income soars to $2.2 billion against $440 million in 1Q2013.

Since the company reported quarterly results, the company has had some significant positive improvements. The biggest momentum came when Seadrill and North Atlantic Drilling announced a new deal with Rosneft to partner in the Russian onshore and offshore market. The agreement will initially contract 9 rigs in the North Atlantic for a total commitment of 35 rig years. Seadrill currently owns 70% of North Atlantic Drilling, but under the agreement Rosneft will aquire a significant equity stake in NADL.

Perhaps the most promising news over the past few months has been the newbuild ultra-deepwater West Jupiter securing a contract with Total Upstream Nigeria Ltd. The contract is for 5 years totaling $1.1 billion, which works out to be around $600,000/day. This is significant because Seadrill undertook such an aggressive newbuild program and the company is facing the real threat of rigs coming online without contracts.

However, it appears management did some strategic maneuvering to relieve some pressure on newbuild contracts by delaying to future deliveries.

"Due to the high volume of deliveries taking place during 2014 and bottlenecks with equipment suppliers and subcontractors, it is likely several shipyards will not be able to meet contractual delivery dates. The yard has informed Seadrill that the West Saturn and West Carina will be delayed up to 6 months collectively from original delivery dates. In addition it appears likely that several of the four ultra-deepwater drillships scheduled for delivery in the second half of 2015 will be delayed by up to 6 months."

This delay will have a meaningful impact on future earnings, as it potentially removes up to 6 months of earnings from new rigs. It is a brilliant move though as it may result in higher dayrates as the industry starts to stabilize and at the same time avoids the psychological impact of multi-million dollar rigs sitting idle.

Recommendation: HOLD/BUY

Source: Howard Weil 42nd Annual Energy Conference

Seadrill isn't for the conservative investor looking for downside protection. This stock is highly levered and lowering dayrates and an oversupply of ultra-deepwater drillships has already affected the company. However, with a dividend yield over 10% and the stock price near 52 week lows, the stock offers good reward for the assumed risk. With 94% of rigs contracted through 2014 and two-thirds already contracted through 2015, the dividend payout is safe in the short-term. Management has also shown their ability to successfully manage their high debt level without sacrificing returning value to shareholders. 4 newbuilds are starting operations in 2014, combined with 6 rigs having commenced operations in 2013, should drive healthy growth in the near-term. The delay of newbuilds coming online is of concern, but is a far better scenario than rigs sitting idle.

Rowan Companies

Three months ended 3/31

($ millions)

2014

2013

Y/Y % change

Revenue

$ 377

$ 394

-4.3%

Expenses

$ 301

$ 304

-1.0%

Operating Income

$ 76

$ 90

-15.6%

Net Income

$ 59

$ 68

-13.2%

EPS

$ 0.28

$ 0.55

-49.1%

Rowan Companies had a disappointing 1Q2014 due to significant downtime from a number of high-spec jack-ups. In particular, the Rowan Gorilla VI and VII, were still undergoing repairs and missed a large portion of quarterly production. The Rowan Gorilla VI is expected to miss the entire 2Q2014 as well. This demonstrates the increased risk investors assume when they buy smaller offshore drillers. Any downtime can have a significant impact on earnings. Despite the operational struggles, the company is well positioned going forward.

The company reached a milestone when the Rowan Renaissance started operations on April 22, 2014, becoming the company's first ultra-deepwater drillship. Rowan has three additional UDW drillships under construction and all have contracts in place. This is a remarkable achievement for Rowan, as many offshore drillers have struggled to secure new contracts for newbuilds. Most recently, the 4th UDW drillship, Rowan Relentless, received a 2 year contract with Freeport-McMoRan (NYSE:FCX) for $425 million. The contract will start in 3Q2015 and will have a dayrate of roughly $582,000. While this is less than the company's three previous newbuilds, it shows management's ability to secure contracts in an extremely competitive environment. With 2 UDW drillships starting operations in 2014 and 2 in 2015, earnings are expected to grow rapidly over the next 2 years.

(click to enlarge)

Source: Rowan Investor Presentation May 2014

With the company's successful launch into the ultra-deepwater market and a current backlog over $5 billion, the company recently initiated its first dividend of $0.40/share. This gives the stock a yield of just over 1%, but the company should be able to increase the dividend payout as newbuilds come online. In addition, capital expenses will dramatically decrease in 2015 as the newbuild program is completed. This will give the company flexibility to increase dividends or pay down debt.

Source: Rowan Investor Presentation May 2014

Recommendation: BUY

Rowan is a high risk/high reward stock. Recent rig downtime has shown the exposure to risk a small offshore driller has when compared to larger companies. However, with the entry into the ultra-deepwater market, the company has tremendous upside over the next 2-3 years.

EPS est.

Q1

Q2

Q3

Q4

Fiscal Year

2016

0.96

1.28

0.96

1.13

4.40

2015

1.02

1.08

0.94

1.21

4.24

2014

0.28

0.29

0.67

1.07

2.37

Source: Rowan analyst earnings estimate

The stock has a mean future 5 year growth rate of nearly 24%, which far outpaces other offshore drillers. If the company can keep operational downtime to a minimum, the earnings growth potential is excellent. Before investing in this high growth offshore driller, investors must decide if the risk is worth the reward. I believe the strong backlog and addition of UDW drillships to the company's fleet makes this stock a buy.

Pacific Drilling

Three months ended 3/31

($ millions)

2014

2013

Y/Y % change

Revenue

$ 225

$ 175

28.6%

Expenses

$ 169

$ 132

28.0%

Operating Income

$ 56

$ 43

30.2%

Net Income

$ 22

$ 15

46.7%

EPS

$ 0.10

$ 0.07

42.9%

Pacific Drilling is a small offshore driller with just 6 rigs and 2 under construction. The company's fleet consists of entirely ultra-deepwater drillships, which makes it the only offshore driller to operate a fleet of 100% ultra-deepwater drillships. The company has increased revenues for 5 consecutive quarters and should continue to do so as the Pacific Khamsin started operations at the end of 2013 and the Pacific Sharav is expected to start its contract in 3Q2014. The 2 newbuilds under construction don't have contracts yet, but are expected to be delivered in 3Q2014 and 1Q2015.

(click to enlarge)

Source: Pacific Drilling Investor Presentation May 2014

Pacific Drilling is 99% contracted for 2014 and 68% contracted through 2015. Three of the 8 total rigs have contracts that extend through 2016. The company has great earnings growth potential and newbuilds will add significant growth going forward.

(click to enlarge)

Source: Pacific Drilling Investor Presentation May 2014

For such a small company to grow at such a fast pace, Pacific Drilling has had to take on massive amounts of debt. The company currently has total debt of $2.4 billion, which is higher than the current market cap of $2.2 billion. This presents a potential problem for the company if they don't receive contracts for their 2 newbuilds or if the contracts receive lower dayrates than they expect.

A few of the financial ratios for Pacific Drilling jump off the page as red flags, but this is only surface deep. The stock has a P/E ratio of roughly 68, which is far higher than any other competitor, but the 12 month forward P/E is just 11. When taking into account future growth from newbuilds, the financial ratios start to make sense over the long-term. Looking at the fiscal year 2015 P/E, it goes to 8.1.

Recommendation: BUY*

I only recommend this stock to investors with high risk tolerance. The company is highly levered and just like Rowan, any rig downtime will have a significant negative impact on revenue and earnings. However, if the company can lock in contracts for their 2 newbuilds and keep utilization over 90%, there is significant upside. Investors must have a strong stomach to deal with the potential large swings in this stock.

Hercules Offshore

Three months ended 3/31

($ millions)

2014

2013

Y/Y % change

Revenue

$ 257

$ 186

38.2%

Expenses

$ 199

$ 168

18.5%

Operating Income

$ 57

$ 18

216.7%

Net Income

$ 20

$ 35

-42.9%

EPS

$ 0.12

$ 0.22

-45.5%

Hercules Offshore has been the biggest loser in the offshore drilling industry over the past 12 months, declining nearly 40% relative to the S&P 500. The company turned in a decent 1Q2014 with revenue increasing 38% year-over-year. Net income was impacted by a $15.5 million used in extinguishment of debt. The company operates in three segments: domestic, international and lift boats.

Domestic offshore revenue increased 18% in 1Q2014 due to rising dayrates. The average rig revenue per day increased 36% year-over-year to $106,596. This was offset by a decrease in utilization to 83% from 95%. The company has seen rising dayrates in the Gulf of Mexico and predicts this strength will continue for the foreseeable future.

Source: Hercules Offshore UBS Global Oil & Gas Conference

The company's largest source of growth has been the international market. Hercules has found success with a number of their international rigs and in particular Hercules 261 and 262. Both rigs are slated to begin 5 year contracts with Saudi Aramco in 4Q2014, which will increase their dayrates 62% and 48% respectively. Most recently the company received a 5 year contract with Maersk Oil for a total contract value of $420 million. However, this contract is for a newbuild that won't begin operations until 3Q2016.

(click to enlarge)

Source: Hercules Offshore UBS Global Oil & Gas Conference

Perhaps the most encouraging aspect of the stock has been the recent insider purchases. As Hercules reaches 52 week lows in 2014, there have been 5 separate insider purchases ranging from $4.35-$4.60. In total, insiders have purchased nearly $680,000 in Hercules stock in 2014. When a stock is at 52 week lows and insiders are buying, it's a very positive sign that internal management believes the stock will go higher.

Recommendation: Strong Buy

At current levels around $4.50-$4.60/share, the stock has very little downside and has seen strong support at these levels. Hercules Offshore has suffered more than any other offshore driller over the last 12 months and is a deep value stock in an over-priced market. The company is growing revenue and should benefit from strength in the Gulf of Mexico. The company has also focused on expanding its international operations and has had great success. All of this combined with strong insider purchasing activity, makes the stock a strong buy in my opinion. When investor sentiment returns to the offshore drillers, Hercules stands to benefit more than any of its competitors.

Conclusion

The offshore drilling industry remains depressed, but has seen positive developments over the past couple months. In a market reaching all-time highs on an almost daily basis, investors may soon begin looking for market laggards. The offshore drilling industry has defined a market laggard over the past 12 months, which gives investors attractive entry points. The industry as a whole has suffered, but the long-term fundamentals in the industry remain strong. Investors looking for downside protection, earnings growth and dividend yield can find several strong candidates in the offshore drilling industry.

Source: Reexamining Offshore Drillers: Buy, Sell Or Hold? Part 3