Why Rowan Companies Plc's Earnings Will Surge Higher And Dividends Will Follow

| About: Rowan Companies (RDC)

Summary

The delivery of Rowan's new drillships will send earnings higher.

Significant free cash flow is expected from 2015 onwards.

Dividends and stock repurchases should follow.

Rowan Companies PLC (NYSE:RDC) is currently finding it hard to find any friends. The company's shares are driving down and have nearly touched a four-year low.

These declines are not just limited to Rowan, concerns about oversupply and lack of demand for offshore drilling services have weighed on the whole sector.

But Rowan is proactively working to ensure that it is not affected by the slowdown. The company is in the final stages of its six-year transformation plan, which should complete next year, and shareholders will see the benefits soon after.

Continuing change

Rowan has completely overhauled its business model over the past few years.

Under the stewardship of recently retired CEO, Matt Ralls, Rowan has worked since 2009 to focus on being one of the best in the space of offshore drilling.

The first part of the plan was to undertake a $3 billion high-specification jackup newbuild program, including the acquisition of the company's revered N-Class rigs. Then came the divestments of Rowan's manufacturing and land drilling businesses.

To increase competitive strength, the company moved its headquarters to the UK, virtually eliminating corporate tax liabilities. The shift helped cut the company's effective tax rate to 3.3% in 2013 from 34.6% in 2008.

The last phase, which is around 50% complete, will drive Rowan's growth to the end of the decade.

Phase four

Phase four of Rowan's transformation plan is the construction of four best-in-class ultra-deepwater, or UDW, drillships. The first of Rowan's new UDW drillships was delivered at the beginning of this year. The Rowan Renaissance commenced operations on April 22, 2014, although the unit experienced problems almost straight away and was forced to take seventeen days off rate time during Q2 2014 for issues with the sub-sea systems.

This problem has now been fixed, and it is not expected to be a recurring issue. The rest of Rowan's four new drillships will be delivered over the next few quarters, with the last delivery slated for the first quarter of 2015.

As taken from Rowan's second-quarter conference call:

"… Our second drillship, the Rowan Resolute, departed Korea in late July will arrive in the U.S. Gulf of Mexico in October. After final commissioning and inspections, the Resolute is expected to commence operations with Anadarko in November. The construction of our third and fourth drillships is proceeding well, with deliveries expected in late October 2014 and late March 2015…"

These drillships are going to turn Rowan's fortunes around, there's no doubt about that. The units are already contracted out, so there is no issue finding customers. The aforementioned Rowan Renaissance, is contracted out from March 2014 to March 2017 at a day rate of $619,000. The three other units have all been contracted out for similar amounts.

With four new drillships in the company's fleet, each demanding day rates upwards of $600,000, Rowan's top and bottom lines are set to rapidly expand as the new units come online. What's more, with contracts already signed for these units, Rowan is likely to miss much of the downturn in the industry.

Now, a day rate of $600,000 is a game changer for Rowan. Currently, as reported at the end of the fiscal second quarter, the company's average day rate was $185,700, around one-third of the rate that the new units will provide.

Overall, when Rowan's four new units come online, they will add $2.4 million per day to Rowan's revenue, approximately $876 million per year, assuming 100% utilization. Rowan's revenue was just under $1.6 billion during 2012, so we can see how much of an effect this will have on earnings.

Rowan's management is expecting these newbuild units to contribute significantly to free cash flow over the next few years starting the second half of 2015. Once again using a quote taken from management on the second-quarter call:

"… expect significant free cash flow to start in the second half of 2015. We are considering our options now for that free cash flow, and we look at all the opportunities. We could grow the company… Secondly, we could return money to shareholders either through a share repurchase or through more dividends… our current thinking is that we wouldn't try to do special dividends. We would try to - that would be onetime. We would try to set a dividend and then maintain it and raise it over time sustainably… With share buybacks, what we will be looking at is opportunistically repurchasing our shares when we felt it was a great investment, when we felt the shares were low…Frankly now we feel that our share prices are at level where it would be attractive…"

So, barring any unforeseen events, Rowan's future is bright and shareholders should benefit.

Troubles ahead

Unfortunately, aside from the delivery of the new drillships, Rowan's existing fleet is facing an uncertain future. As I have covered here, the global jackup rig fleet is entering a period of oversupply. 30 out of Rowan's total 34 rigs are jackups.

Now, to some extent, Rowan's reputation will help it avoid much of the slowdown (companies are willing to pay a premium for experienced crews to prevent a repeat of the Macondo disaster), but risks remain. On the first-quarter conference call, Thomas Burke, president and chief operating officer of Rowan commented:

"… I do not foresee any significant changes to our strategy…Although certain sectors or markets have softened in recent months and many new rigs are entering the market, our current backlog, capable young fleet and operational expertise continue to provide a solid foundation for Rowan…"

And this dismal view on the market was reiterated on the company's second-quarter conference call:

"…Worldwide jack-up utilization is currently at 86%, down from 89% at our last call. After a steady 3-year increase, we believe the market has reached an inflection point in global utilization. With influx of new supply, we're seeing downward pressure on both day rates and length of term in some operating regions…"

Nevertheless, Rowan has made a strong start to the year in terms of contracting. The company started the year with 19 jackups set to roll off contract. So far, seven of these units have had contracts extended. Further, the company is tracking visible demand for 17 term projects scheduled to commence within the year.

Over the longer term, however, Rowan's future is more uncertain. With such large portion of the company's fleet jackup, there is a chance that earnings will slump as demand collapses within the jackup market.

141 newbuild jackups are currently in the process of construction, only 18 of which are already committed. That leaves 123 jackups that need a contract. Management believes that around 27 of these units are intended for captive markets and will not be competitive with Rowan rigs. A further 73 of the remaining 96 uncontracted newbuilds are considered to be speculative and could be cancelled before completion. Even if all of these 73 units were cancelled, there would be 23 units remaining that needed a contract.

Investors need to key an eye on how this trend plays out over the next few quarters, although it's likely that the additional income from the drillships will mitigate much of the jackup market downturn.

Conclusion

So all in all, Rowan's earnings are set to jump over the next few quarters as the company's brand new drillships start to contribute to earnings. However, the company is facing headwinds, most noticeably within the jackup rig market.

Nevertheless, Rowan's management remains upbeat about the future, and believes that as the newbuild program completes, Rowan will be set to generate significant free cash flow from 2015 onwards. This free cash flow generation should support dividend payouts, buybacks or further fleet growth. Great news for shareholders.

Disclosure: The author is long RDC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.