Tidewater Is Trading At 75% Of Tangible Book Value But Watch Angola And Industry Oversupply

Summary

• Tidewater is trading at deep discounts using several valuation methods.
• However, despite negative offshore drilling services sentiment, the future industry outlook is very uncertain and the situation could get much worse before Tidewater stock bottoms.
• Tidewater also has company-specific risks such as high share of revenues from the troubled Angola and other politically and economically unstable regions, such as Venezuela and Brazil.
• Therefore, investors should start buying carefully with a plan to spread out the purchases in time.
• Over several years, the stock offers at least a 27% upside plus 2.5% dividends to patient investors with a current DFCF target price of $49.50 per share.

Tidewater, Inc. (NYSE:TDW) is a global provider of vessel and support services to offshore drilling companies. Tidewater has been established since 1956 and provides services in support of offshore exploration, field development and production, including towing of and anchor handling for mobile offshore drilling units, supplies and personnel, as well as a broad range of other related support services throughout the lifetime of drilling operations. Approximately 57% of vessel revenue comes from deepwater and 35% from towing supplies, with other services accounting for 8%.

Investment thesis

With the U.S. dollar index gaining another half a percentage point recently and even more against the Euro amid global growth concerns and tighter U.S. monetary policy, the pressure on commodity prices, including oil and natural gas, from the strengthening dollar does not seem to be abating anytime soon. However, the slump in stock prices of offshore drilling oil and gas services companies has created a multi-year buying opportunity for patient investors.

Tidewater, one of world's largest offshore drilling services companies, currently trades at a steal valuation based on multiple valuation methods, including a DCF fair value and historical comparison. It is also one of the cheapest plays within its peers. The stock trades at 75% of its tangible book value which mostly consists of modern vessels. The estimated fair value using DFCF analysis is ~$49.50, offering a ~27% upside plus a 2.5% dividend. By historical standards, Tidewater is ~40% undervalued and trades at the lowest P/B and P/S values in the past 10 years, including the 2008/2009 period with P/B of 0.7 and P/S of 1.31. Forward P/E is 7.5x.

There are very few industries so out of love with investors and so undervalued at the moment as the portions of the oil and gas industry services. Perhaps only the mining industry is in a more dire situation and a bit ahead in the cycle, as there are already signs of major banks cutting the lending, so interest costs will rise at the worst moment for the mining industry. The situation is not that bad yet in the offshore drilling services market.

However, some companies in the sector have already started issuing shares instead of taking on more debt, so there are signs of this trend extending from mining to the oil and gas services industry within the next several quarters. The likely U.S. interest rate tightening could accelerate this credit crunch trend, so the worst for the offshore drillers still seems to be a few quarters in the future. Additionally, overcapacity is expected to last until mid-2015 as more vessels are still expected to come online due to the lag caused by long building times of vessels. The strong dollar will also be a headwind for the foreign portion of Tidewater's Q3 earnings.

While I think that the oil and gas industry is still a few quarters away from its absolute bottom of this cycle, the markets are usually a few quarters ahead and seem to have priced in most of the known expected headwinds lying ahead. Therefore, now is the right time to start investing into the undervalued offshore drilling services companies, such as Tidewater, as they are very likely to start bottoming between now and the next six to nine months. Spreading purchases in time to dollar-cost-average into the current weakness is the recommended strategy.

A very young fleet of vessels with an average age of ~7 years for newer vessel types

Tidewater currently owns or charters 275 vessels and 6 ROVs, excluding the joint venture operations. The average age of all vessels is ~9.4 years. The relatively new vessels built after 2000 account for roughly 90% of all vessels and even higher 96% of revenue, and their average age is ~7 years. With 33 more vessels ordered or being currently under construction, the company will essentially have complete modernization of its fleet. With a reasonable expectation of a useful life of 25 years or more, Tidewater will in two years enter into a long period of high free cash flow generation as capital expenditures will drop dramatically and the company will be able to quickly repay its debt and increase dividends and share repurchases.

TTM capital expenditures are already falling from the recent peak level of investments made in the fiscal year ending March 2014, so this trend of lower CAPEX is beginning right now. While operating cash flow has been positive, free cash flow has been negative since 2009 due to heavy investments to fleet modernization, which is now almost over.

Current situation: Asia/Pacific towing-supply business falling

For the fiscal Q1 2015 ending June 30, 2014, Tidewater reported net earnings of $43.7M, or $0.88 per share, 44% higher Y/Y and flat Q/Q, helped by an acquisition and debt taking. Revenues reached $385.7M, up 15% Y/Y and 5% sequentially. Generally, all regions show healthy operating margins with the overall EBIT margin of 15% for calendar Q2, 2014. The negative exception is the Asia/Pacific region, where crew costs and repair and maintenance costs contributed to a negative EBIT contribution from this region in Q2, as revenues earned on towing-supply vessels fell 15% Y/Y and prompted higher costs associated with relocation of underutilized vessels to other regions with higher demand. Gaps between Australian projects were the cause of the decline. Tidewater also logged a $1.3M foreign exchange loss related to the weakening of the U.S. dollar relative to the commodity currencies. This negative trend should be reversed in Q3 as the U.S. dollar strengthened significantly.

Total vessel utilization reached 83.7%, up Y/Y but down Q/Q for the newer vessels that account for ~90% of sales. Average day rates were $18,701, up 9% Y/Y and 7% sequentially, so the overall market is still healthy with deepwater day rates at ~$31,000 and towing-supply rates reaching ~$15,200. Vessel cash operating margin reached 43%.

Tidewater continued in its sales/leaseback activities, performing one additional vessel sale this quarter. The deferred gains on sale of vessels are expected to reach $3M per quarter in the near future.

The Angolan market situation is unstable and negative. Angola accounts for roughly a quarter of total revenues

Tidewater is still actively exploring ways to continue profitable participation in the Angolan market while reducing the overall level of exposure of the company to the increased risks that the company believes currently characterize the Angolan market. After having an average vessel count higher by one vessel in Q1 in Angola, Tidewater reduced the net vessel count by 9 vessels during Q2. Other foreign operations include, among others, Venezuela, Nigeria and Brazil, most of which are politically and economically unstable regions that pose a significant risk.

The Angolan payments are uncertain due to capital controls and forex arrangements

The challenges for the company to successfully operate in Angola remain significant, especially due to a tight forex regime of the country, which effectively equals a capital control regime where Tidewater needs to take payments in the local currency. There are risks that it will not be able to convert them to U.S. dollars, or that the local currency will devalue and conversion costs and possible repatriation taxes will be high. The company is in the process of finding a workaround in order to get paid in U.S. dollars at least on a portion of its Angolan revenue, but the solutions is at risk of being rejected by the Angolan authorities as the interpretation of the law is not clear. However, the solution is used by other foreign companies in Angola.

In total, Tidewater's Angolan operations generated vessel revenues of approximately $87M, or 23% of consolidated revenue for Q2 2014. So this risk is not negligible and poses a threat of a loss of all or part of roughly $430M, which is currently due from Angolan operations and have been accruing, waiting for a workaround to be received in U.S. dollar rather than the Angolan currency. This new workaround is currently already successful and results in ~70% of all Angolan payments to be received in U.S. dollars, with the remainder being received in Angolan currency, kwanza. The solution is resulting in gradual payments higher than the current sales revenue, so the total amount owned is very slowly decreasing. However, the accrued amount due remains high and it is impossible to predict whether the current solution will keep working in the future, depending on the Angolan central bank.

Future growth prospects very uncertain; rates and utilization likely to fall

The company has a very well balanced stream of revenues regionally, covering many diverse worldwide oil and gas locations. This provides relative stability to the company's revenues and also gives the company an option to relocate vessels between regions based on changing demand and day rates. Currently, the Asia/Pacific region is weaker, led by Australia. Angola is expected to weaken and poses an ongoing threat. The company has begun gradually decreasing its exposure to this region.

For the rest of fiscal 2015, deepwater day rates are expected to remain in the $30,000 to $31,000 range, slightly down from Q2. Towing-supply rates should stay within the $15,000 and $16,000 range, slightly down from current levels. This shows that the company itself expects some weakness in the day rates. However, vessel cash operating margins should slightly improve Q/Q to 43% to 45% due to lower expected maintenance and repair costs. Vessel revenue should reach between $380M and $390M.

For the record, the company's management expects an "extended but at times choppy" offshore industry up cycle. The management thinks that current analysts' and investors' concerns regarding the potential slowdown in offshore drilling and its impact on Tidewater are overblown. The management calls the current situation as "akin to indigestion," expects the market to find equilibrium again within 18 months and doesn't see the issue of falling demand, but rather just the supply of vessels rising too fast. As older vessels are laid to rest, the market should find balance within 18 months. The future will tell.

Finding the supply-demand balance may take longer than expected as any overcapacity will be hard to remove due to high CAPEX already invested and waning interests of operators to continue operating older vessels that are already written off or almost written off, even at day rates that are much lower than current market rates. In any case, the future outlook for the offshore drilling services industry is probably as uncertain as it has ever been for the past couple of years, so the caution expressed by the stock market is warranted. But it also presents once-in-a-decade buying opportunities in offshore drilling services companies.

Valuation: price at 75% of tangible book value

The stock trades at 75% of its tangible book value, which mostly consists of modern vessels that usually can be sold above their purchase price (when accounted for depreciation). However, if the industry overcapacity worsens and financial conditions tighten, Tidewater and its peers may be forced to sell assets at fire-sale prices -- well below the current favorable levels. So the tangible book value is not a safe-haven under distressed conditions.

Historical valuation: 40% undervalued, trading at lowest values in 10 years

Using historical comparison, Tidewater is ~40% undervalued and trades at the lowest P/B and P/S values in the past 10 years including the 2008/2009 period, with P/B of 0.7x, and P/S of 1.31x. The forward P/E of 7.5x is also very attractive.

DFCF fair value provides ~27% upside plus 2.5% dividends

The estimated fair value using DFCF analysis is ~$49.50, offering a ~27% upside plus a 2.5% dividend.

Source: author's calculations

Risks of overcapacity when future capital commitments are still high

Going into the cyclically weak period and overcapacity, there is a risk that the ROI of the currently committed investments into fleet renewal will be lower than expected. The value of the total capital expense commitments to acquire and construct new vessels currently reaches almost $1B, of which ~$350M has already been invested and ~$650M is still to be expensed. The company will need to raise the debt as the expenses will most likely not be fully covered by generated operating cash flow. Higher debt will mean higher interest costs, at a time when credit conditions are likely to tighten overall.

Source: Tidewater's 10-Q filing for the quarter ended June 31, 2014.

A very solid debt position offers room for weathering the potential industry storm

The weighted average interest rate paid on debt is roughly 4.5% and the weighted average remaining life to expiration is roughly 7 years. This is a very solid financial position, which gives Tidewater plenty of room and time to continue investing and withstand a cyclical down market and likely rising interest rates.

Crew costs continue to rise due to shortage of highly skilled workers required by modern vessels

Labor costs account for more than a half of all vessel operating costs and 31% of vessel revenues. As the company (and the entire industry) introduces more modern vessels into its fleet, the labor shortage of highly skilled workers worsens. However, as the growth rate of the new vessel additions is likely to fall from 2015 onward, the wage pressures could ease. However, they will certainly pose a long-term challenge to maintaining margins.

Conclusion

Tidewater is trading at some of the lowest valuations in the past 10 years using multiple valuation methods. It is ~27% undervalued using a DFCF valuation with a fair value at $49.50 per share, and it is trading ~40% below average historical P/S and P/B figures and at 75% of tangible book value. But despite the very cheap valuation, there are plenty of political and economic risks looming that are specific to the company in addition to the uncertainty in the general offshore drilling services market, potential major overcapacity and down cycle.

As a result, investors should start building long positions in Tidewater, but they should spread out their purchases over time because the uncertainty of the outlook is very high and the situation could easily get worse before the stock finally bottoms.

Analyst’s Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.