The P/E discussion has finally evaporated from the comments section of articles on offshore drillers. Frankly, I expected that P/B discussion will also go the way of dodo, but I was wrong.
If the P/B argument is so popular, let's look at it in more detail.
Atwood Oceanics (NYSE: ATW)
Diamond Offshore Drilling (NYSE: DO)
Ensco (NYSE: ESV)
Noble Corp. (NYSE: NE)
Ocean Rig (NYSE: ORIG)
Rowan (NYSE: RDC)
Transocean (NYSE: RIG)
Transocean Partners (NYSE: RIGP)
Seadrill (NYSE: SDRL)
Seadrill Partners (NYSE: SDLP)
Pacific Drilling (NYSE: PACD)
Obviously, dynamics of the P/B ratio are dependent on the price part of the ratio. The lower the price, the more attractive a stock becomes from the P/B point of view. If P/B was the only reason why you buy stocks, buying candidates would have been obvious - Ocean Rig and Pacific Drilling.
In this article, I'll analyze the extreme case of Ocean Rig as well as the less extreme but probably more attractive case of Atwood Oceanics to show why P/B does not matter at all and won't matter for the time being in the offshore drilling space. Let's start with Ocean Rig.
The company currently has five working drillships (Ocean Rig Corcovado, Ocean Rig Poseidon, Ocean Rig Mykonos, Ocean Rig Skyros, Ocean Rig Athena) and one working semi-sub (Leiv Eiriksson).
Three drillships (Ocean Rig Olympia, Ocean Rig Paros, Ocean Rig Mylos) and one semi-sub (Eirik Raude) are stacked. The company has previously agreed to transfer the ownership of Ocean Rig Apollo to a trustee.
Judging by the book value, the company should be worth $3.25 billion while its market capitalization is just $65 million. I believe that everybody will agree that the book value overstates the real value of Ocean Rig's assets, but does it inflate them so much?
Let's see. We know that the value of the stacked drillship Ocean Rig Paros is $65 million in the current market environment. There were no deals after the Paros purchase, so this value already looks like a conservative assumption.
I'll use for all three rigs - Olympia, Paros and Mylos. Together, they are worth $195 million. The older semi-sub without a work is really worth nothing in the current environment.
Let's turn to working rigs. They are certainly more expensive than stacked rigs as they have contracts in place and deliver positive cash flow.
Despite this, I doubt that Ocean Rig's working rigs are worth more than $1.5 billion - $1.6 billion or $300 million - $320 million per drillship on average.
The semi-sub Leiv Eiriksson continues to work and could even secure an extension to the current contract, but I'm not putting much faith into the value of the rig. In total, even with generous assumptions, the current value of Ocean Rig's rigs is below $2 billion.
Drilling units, machinery and equipment stood at $6.25 billion in the second quarter according to the company's balance sheet. Thus, there's likely at least a $4.25 billion difference between the book value and the actual value of assets and the stockholders' equity is negative.
That's why Ocean Rig's market capitalization is just $65 million and the stock trades as an option on oil prices as well as on George Economou's financial genius, which should bail out the company according to the bullish thesis.
Now that we've seen that referring to the book value in Ocean Rig's case is meaningless, less turn to a company in a better financial situation - Atwood Oceanics.
Atwood Oceanics' current market capitalization is $435 million while the latest 10-Q boasted shareholder equity of $3.2 billion. Once again, the resulting shareholder value is based on the property and equipment evaluation, which, in Atwood's case, stands at $4.2 billion. However, how much are Atwood's rigs worth today?
The company currently has 4 working UDW rigs - Atwood Achiever (on a standby 95% rate), Atwood Advantage, Atwood Condor and Atwood Osprey.
In October, the whole jack-up segment will find itself without work as Atwood Orca rolls off the contract. The semi-sub Atwood Eagle, which was built in 1982, is being actively marketed but will it ever find work again?
I don't think that the current value of Atwood's fleet exceeds $1.2 billion and even this number seems too generous to me. As in the previous example, the stark contrast between the nominal value of assets and their market value eliminates shareholder value. Just like in the Ocean Rig's case, book value and the P/B ratio are absolutely meaningless in determining whether the company is a good investment.
Will book value matter in the future?
You can forget about looking at the nominal book value of offshore drillers for the time being. Several offshore drillers already negotiated with their lenders and they won't mark-to-market the value of their rigs in order to stay within covenants.
I have to note that it's hard to estimate the real liquidation value of any given driller as there is no market for any significant number of rigs. In this light, estimates of the current value of the fleet are purely theoretical and won't be tested in practice.
Of course, the value of any company's fleet will dramatically go up when the offshore drilling market stabilizes, work shows up and day rates increase.
However, not every driller will still be alive at that time (at least not with the current capital structure). It looks tempting to look at any drillers fleet, try to guesstimate its value in, say, 2021, and speak about tremendous upside.
However, for this to happen in reality, a company must first survive with the current capital structure. In this light, the main valuation factor is the survival potential rather than any potential value of the fleet.
It turns out that companies with higher nominal P/B ratio will likely be better performers than the "dramatically undervalued" peers as those peers may have real trouble with survival.
In my view, Diamond Offshore Drilling and Rowan continue to stand as the best survival candidates, while Noble Corp. is becoming increasingly interesting due to the recent downside. Meanwhile, the companies with an absurdly low P/B ratio look like a pure gamble.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: I may trade any of the abovementioned stocks.
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