Drilling For Contrarian Value In Oil And Gas: Consider Oceaneering

Summary

Anything related to Oil & Gas has declined substantially over the last 3 months in a period when the S&P has been flat. There has to be value here somewhere.

Started my search with those worst hit: offshore drillers. Came away from research on RIG disheartened. Next step was to look down the industry supply chain for an indirect play.

Enter OII: manufactures ROVs and provides a range of support services to offshore drilling industry.

A high quality company: strong management and governance, significant competitive advantages, a record of very profitable growth, and generally good prospects.

The stock looks undervalued at 8x EBITDA. I see upside of 30% to $85. Considering the opportunity costs of my book, though, I am looking for a bit more value.

I am not recommending the purchase of a security in this article, but shedding light on one that I believe to be attractive at this point. It may or may not become worth buying over the next 3-6 months, but I believe it is certainly worth following now. The company is Oceaneering International (OII).

Background

I've watched anything related to Oil & Gas tank over the past few weeks, and it has made my contrarian senses tingle.

A 1-month decline of 7% - 17% in several related industries over a period when the S&P has been essentially flat is atypical and is worth looking into. Is such a decline really justified? I naturally suspect it isn't, at least for some of the companies that have been hit. There has to be value somewhere in this mess.

I started by looking in the industry hardest hit recently - offshore drilling. I read Transocean's (RIG) 10-K, and came away sort of disheartened. Below are my exact takeaway notes from the 10-K:

The offshore drilling industry:

-is highly competitive, particularly on price (competitive bidding process, 'day rate,' price listed first among competitive factors, companies seem to be almost entirely price takers)

-it's economically-sensitive / cyclical

-there's significant regulatory/legal risks (RIG will probably end up paying $1.4-2B from Macondo and its contractual indemnities with BP were not honored by US courts, so it's difficult to mitigate too)

-and capital-intensive (RIG has earned a 11.8% ROIC over LTM and that's ex-cash, ex-goodwill, and pre-tax) and intuitively when you consider they're paying hundreds of $M for a single rig

The two counters I expect to hear regarding the low ROIC are:

  1. It's a cyclical industry, so LTM may not be representative of the average year's performance.
  2. It is a PPE heavy industry. Rigs can last 40 years, but companies don't depreciate over that long a period, so EBIT may understate earnings power.

In the graphic below, I calculated RIG's ROIC at various points in the cycle:

Margins, capital turnover, and ultimately ROIC, do fluctuate a great deal throughout the cycle, but even the high point is average at best considering the generosity of the calculation (excludes cash and goodwill, and is pre-tax), and the low is unacceptable. Regarding the distortion related to aggressive depreciation, I think the ROIC calculation sort of deals with this by its nature. If companies depreciated rigs over a longer life, EBIT would be higher, but so would PP&E. They'd offset each other and the result would be very similar.

RIG and other offshore drillers do trade at very low valuations, but I generally prefer high quality companies at very good prices to okay-poor companies at great prices, and I'm not so sure the offshore drillers are even trading at screaming-buy valuations yet.

For many investors, the train stops here, and I can understand why, but I'm looking for a different quality profile, and so my search continues.

A mentor once told me something to the effect of the following:

If you don't understand an industry or you find its risk/reward profile to be too high, find a business in another spot on the industry supply chain that benefits indirectly from the same broad idea, but also fits your criteria and lies within your circle of competence.

This is exactly the step I tried to take following my research on RIG. I found a company in Oceaneering that does not drill for oil offshore directly or contract the rigs, but plays an integral support role by providing remote-operated vehicles ("ROVs") that dive to depths human divers cannot to repair/maintain/adjust deep water and ultra-deep water rigs, among other products and services that support offshore drilling. The business is related to offshore drilling, but it isn't really levered to rig dayrates or the price of oil to the same extent it is the number of contracted offshore rigs at any given time (related to dayrates) and E&P capex (related to the price of oil). It seems to be a much less hypersensitive, more indirect way of playing offshore drilling and more broadly, oil & gas, and yet the stock has still declined about 17% over the last 3 months and 25% from its all-time high in late 2013.

A Good Business…

I think Oceaneering is a high quality company - maybe 7/10. This is based on:

  • Strong management/governance
  • Substantial competitive advantages
  • Record of value-creating growth
  • Good prospects

Strong Management/Governance

CEO M. Kevin McEvoy has been with the company for 30 years. McEvoy and the company in general have excellent ratings on Glassdoor:

Source: Glassdoor

The 10-K and investor presentations were informative and, having been with the company so long, the current c-suite is responsible for a lot of the firm's success over the past 10-15 years.

Substantial Competitive Advantages

Oceaneering does many things, but 42% of operating income comes from ROVs and I think this segment opens the door for other OII products/services. The company has competitive advantages in ROVs because of its:

  • scale / market share
  • enduring client relationships
  • manufacturing and operating expertise in a very technical niche

OII's ROV fleet makes up 35% of all ROVs globally and has 60% market share on floating drilling rigs:

Source: OII Sept Investor Presentation

The company does the bulk of its business with E&P giants like BP (BP), which accounted for 18% of 2013 revenue. The company has been doing work for Petrobras (PBR) since 1979. These are global companies, and as such, they typically prefer contractors who share their global scale.

Great evidence of the advantages of scale and close relationships with the biggest E&Ps is demonstrated in the following from the 2013 10-K and Sept Investor Presentation:

We estimate approximately 29 floating rigs will be placed in service during 2014, and we have ROV contracts on 16 of those. Competitors have the ROV contracts on three rigs, leaving 10 contract opportunities.

In the first case, OII has 16 of the 19 contract awards and in the second, OII has 19 out of 21. The company actually seems to be gaining share.

After reading the 10-K, viewing some photos, and watching a short clip of an ROV in action, it becomes very apparent that ROVs are complex, highly technical machines.

Source: OII IR

I suspect that they would be far easier for an engineering team to iterate and improve than reverse engineer and build from scratch. Further, this excellent article brings up the good point that these vehicles also demand expertise to operate and OII benefits by operating its own machinery.

Record of Value Creating Growth

In the past, OII has (1) grown at a high rate, while (2) maintaining good, improving ROIC. This has allowed much of the growing value to pass through to shareholders, and indeed, (3) OII stock has delivered outstanding total returns over time.

1 - Growth

OII has been a 15-20% grower over the last 5-10 years and, while some reduction should be expected as the law of large numbers is at play in ROVs, there are plenty of adjacent support service markets where the company can continue to find growth. I don't think an expectation of 10-15% EBIT growth is unreasonable.

2 - ROIC

OII has improved its ROIC substantially over the last few years and is now doing 30-40%. My standards have become high because of the non-representative high quality sample of companies I typically look at, but 30-40% is good. Not great, but very good. There is still a capital-intensivity to ROVs as they are big, expensive machines to build. There is also a lot of net working capital in the business which makes sense considering customers are typically much larger companies than OII and do a lot of business with the company. They are probably able to leverage their size and the importance of their relationship to OII for attractive payment terms. Still, 30-40% is not bad and has allowed some of the growing cash the business is generating to flow to shareholders. The difference between a poor ROIC, high growth business and a good ROIC, high growth business is shown below:

3 - Total Returns

I touched on this in previous points, but OII's long-term shareholder returns are outstanding. I source ideas from a list of the 250 best 10 year charts, and despite the decline over the last year, OII is on that list. It is up sevenfold over the last ten years, or 22% annually:

My thought process is: there are few better indicators of companies that will deliver great returns over long periods in the future than great returns generated over long periods in the past. Further, the elements that enabled OII's great returns - much of what I have already mentioned and will mention like ROIC, management, etc. - are still in place.

Good Prospects

I expect this to be the most controversial element of my thesis as:

  • the decline in oil & gas stocks has largely been driven by concern about the price of oil and dayrates
  • OII stock has declined with its peers

Deductively then, one would think that OII's prospects are not good. However, as previously mentioned, OII is not directly levered to these numbers. More important than oil prices and dayrates are the number of contracted offshore rigs and the amount E&Ps are spending on offshore capex. The outlook for these numbers is not so bad and intuition makes me think these outlooks are accurate.

From my research, the situation seems to be as follows:

Contracted rigs and E&P deepwater capex have increased at a good rate over the past decade, and yet offshore production has declined, so the cost/barrel has increased a great deal. According to Seadrill:

Since 2005, 314 additional rigs [have entered the market]... increasing the fleet by approximately 53%. The production of oil offshore has in the same period decreased from approximately 24 million barrels per day to 22.5 million barrels per day.

Due to a combination of offshore production becoming more costly and an uncertain price of oil, E&Ps are trying to rein in expenditures, but are also having trouble producing enough oil in the heavily tapped onshore and midwater areas. The world still demands oil. Technology is improving and making deepwater and ultra-deepwater drilling more feasible and this is the least tapped area, and so E&Ps will have to continue to invest here, and eventually invest more, it's just a matter of when.

Fracking is the big buzzword right now and what most people would substitute above for "deepwater and ultra-deepwater drilling," but the production curve for fracking is much more severe than for a typical oil well:

It should also be considered that wells drilled in tight formations have a very rapid decline rate, much more rapid than wells in conventional oil and gas deposits. The decline rate is of the order of 40% in the first year and around 90% after four years (as shown in the next figure). The bottom line is that maintaining production requires constant drilling of new wells - and increasing production even more so. Exploiting tight oil and gas is, therefore, a labor and machinery-intensive process, more akin to manufacturing than to mining in its economic profile.

Source: OilPrice.com

Over the long term, E&Ps will need to get much of incremental oil production from deep and ultra-deepwater wells.

To quantify the prospects for the next few years, OII is looking for 10% growth in contracted floaters over the next 5 years, or 2% annually:

Source: OII Sep Investor Presentation

Some might think this projection unrealistic, but it is important to recognize that this is only the number of floaters contracted, not the dayrates on those floaters.

The other important metric, deepwater capex, is expected to grow substantially:

Source: OII Sep Investor Presentation

With mixed indicators, I tend to think industry growth will be more moderate over the next 5 years than it has been in the recent past, but I don't think it will be poor. I think it will be an environment that OII can continue to profitably grow at a double digit rate in, but the growth will probably be slightly toned down. The larger, more important point is that the outlook remains generally good.

…At A Good Price

The stock trades at about 12x EBIT, 8x EBITDA, and 16x P/E. These are below-market multiples for what I perceive to be an above-average company. More specifically: 10-15% growth + 30-40% ROIC + good prospects, competitive advantages, and other qualitative factors should not equal 8x EBITDA and 12x EBIT. These multiples are also below historical multiples the market has placed on the business. If you look at a 5-10 year chart, OII looks to typically trade at 22x P/E, 14-15x EBIT, and 10-11x EBITDA. I read an article from a credible writer claiming that the offshore drillers typically fetch 7-8x EBITDA. Since I've established that I believe OII is a much higher quality business than the offshore drillers, it doesn't deserve to trade at an offshore driller multiple.

All that said, when I consider the opportunity cost of other things on my plate in other industries, OII does not look ridiculously undervalued. I don't want to talk my book, but one name I wrote about recently in Sturm, Ruger (RGR) is available at 6x LTM EBIT and about 8x forward EBIT despite having much higher ROIC (100%+) than OII and a similar growth profile. I think OII is probably worth about 10-11x EBITDA or about $85 per share. That's upside of 30% from here. That's pretty good in this market, but I'm looking for just a little bit more, so I am not buying at this price. However, if the Oil & Gas negativity continues, which it very well could, OII could be dragged down another 5-10% and become a no-brainer.

Disclosure: The author is long RGR.

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.

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