The recent downward trend in oil prices has affected several companies. However, it is important to remember that generally, during times of uncertainty, opportunities are created. Among these, I present a simple investment thesis in Atwood Oceanics (NYSE:ATW), after taking a look at the company's financial statements through a value investing approach.
According to the company's website:
Atwood Oceanics is an offshore drilling company, engaged in the drilling and completion of exploration and development wells for the oil and gas industry. The company owns 11 mobile offshore drilling units and is currently constructing two ultra-deepwater drillships. The company was founded in 1968 and is headquartered in Houston, Texas.
So basically, the company owns drilling and exploration rigs and rents them to other global companies to extract oil. Among its most important clients we find Apache Energy Ltd, Chevron Australia and Shell Offshore Inc, among others. Logically, as global supply has exceeded demand, companies have reduced their capital allocation towards exploration projects, reducing the number of contracted rigs for Atwood. These concerns have brought down the price significantly, providing an attractive upside and strong downside protection.
While generally companies in the oil sector have several components and turn out to be complicated for valuation purposes, Atwood is a fairly simple business with a strong balance sheet, capable management and a good track record.
A Conservative Valuation
One of the aspects that I like about the company is the transparency with which they talk about future prospects. They have accepted that there is a lack of visibility heading towards 2017, which could mainly explain the recent fall in Atwood's share price. Also, it is important to remember one of Ben Graham's most important quotes:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
With this in mind, I am not suggesting to step over the lack of earnings visibility to value Atwood, but I am suggesting to stress Atwood's balance sheet to reach a liquidating value estimate and see what would be available for shareholders after all is done.
First, I would like to quote Ben Graham on this approach and how can it be useful:
When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated. Two corollaries may be deduced from this principle: Corollary I. Such a price should impel the stockholders to raise the question whether or not it is in their interest to continue the business. Corollary II. Such a price should impel the management to take all the proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business."
If the company is not worth more as a going concern than in liquidation, it should be liquidated. If it is worth more as a going concern, then the stock should sell for more than its liquidating value. Hence, on either premise, a price below liquidating value is unjustifiable."
There is a much wider range of potential results that may result in establishing a higher market price. 1) The creation of an earning power commensurate with the company's assets, resulting from a) General improvement in the industry or b) Favorable change in the company's operating policies. 2) A sale or merger and 3) Complete or partial liquidation."
The Investment Thesis
Based on this approach, it is my belief that the company will not be liquidated but will take the correct measures for the market to recognize its value. The company has already reduced its dividend, which provides more flexibility for the near future. In terms of catalysts, I believe that Atwood has slightly over a year before suffering irreparable losses or damage. So taking the ideas from Graham, I believe that a general improvement in the industry is likely to take place and that the company's operating changes have already been taking place and are likely to continue.
The company has 11 rigs operating and being actively marketed at the moment, while delaying the delivery of another 2 rigs which are new. Atwood has already incurred in a $64 million impairment during 4Q15 for one of its rigs, the Atwood Falcon. It is very important to note, however, that this rig was constructed in 1983, and that the average construction date for the 11 rigs that are currently operating (excluding the 2 new delayed rigs) is 2009.
Due to US GAAP accounting rules, an impairment occurs when the value of estimated future cash flows is less than the carrying amount of the asset. However, in spite of the lack of disclosure by the company in terms of individual depreciation on its rigs, I believe that another impairment is unlikely, at least in a large scale. However, if conditions persist, this is something that could pose a risk to a percentage of the fleet.
I have taken two different approaches to value Atwood. The first one is the Graham Liquidating Value, which assigns a multiplier or discount to assets and deducts total current liabilities. The second one is another liquidating approach that deducts total liabilities instead of only the current ones, which I call a common sense liquidating value.
A company's balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints that may prove useful. The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value ascribed to the assets, however, will vary according to their character."
For the first approach, which is explained with greater detail in Security Analysis, I have assigned a multiplier of 80% and 50% to the receivables and inventory accounts respectively. Total current liabilities have been taken at a 100% multiplier. Regarding long-term assets, which is Atwood's main component, I have stressed the value significantly, thinking about a fire sale or an extremely severe impairment charge, applying a multiplier of 20%, and the same number to the deferred charges account. With this, the net total assets for the company amount to about $1.1 billion, which would imply $17 on a liquidating value per share.
The second approach, is a common-sense one in which I pose a liquidating scenario: The company decides to fire sell its rigs, pay down all debt and distribute the remaining cash to shareholders. For this approach, I have assigned the same multiplier than in the previous example to the cash, receivables and inventory accounts. However, I have adjusted the net plant account with a 45% multiplier given the 2009 average construction date of the rigs. This provides a $7.70 liquidating value per share.
You will note that both these approaches are very conservative provided the probability of a fire sale and the lack of a rebound in oil prices during 2017 as assumptions. It is important to note also, that on a yearly basis, depreciation has only been about 3% of the company's net plant and equipment account.
I have weighted these approaches with a 30% probability for the Graham's liquidating value and a 70% for the common-sense approach. With this, my weighted average target price is $10.20, providing a 40% upside potential with very limited downside, provided the value of the assets.
You might still be worried about earnings and the lack of visibility towards 2017. In my opinion, the main risk is that the overall rig supply is still growing, which could either make day rates decrease and/or increase the idleness of the fleet. I agree that these pose a significant threat; however, Atwood's fleet is relatively new and able to compete in a tough environment. Also, the balance sheet is strong and makes the company resilient.
With this in mind, I believe Atwood is one of the best asset plays for the near future, providing an attractive risk/reward ratio.
Disclosure: I am/we are long ATW.
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.