The Story Behind Rowan's Increasing Return On Equity

| About: Rowan Companies (RDC)
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Summary

The increase in ROE is primarily due to an increase in profit margin.

The increase in profit margins is opposite of what other offshore drillers have been doing in the category.

The ROE can increase significantly if Rowan can lever up to buy a distressed asset at the bottom of this oil drop.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders equity on the balance sheet. Companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) even have huge returns on equity. Typically a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont (NYSE:DD) back in the 1920s. The decomposition of return on equity tells us three things:

  1. Operating efficiency, which is measured by profit margin
  2. Asset use efficiency, which is measured by total asset turnover
  3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we multiply them all together we get the following proof:

Profit

*

Sales

*

Assets

=

Profit

=

ROE

Sales

Assets

Equity

Equity

I for one am looking at return on equity in a much different manner now after learning this method. The part of the proof above that got me to investigate ROE more intently is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally I don't like a whole lot of debt on the balance sheet. But for capital structuring reasons debt can be used as a tax shield as taxes are calculated after interest payments.

I've chosen to evaluate Rowan Companies PLC (NYSE:RDC) today because since I've been writing about the company about a year ago, the return on equity has been a bumpy ride. For the past few months that I've been looking at the stock it has had the return on equity profile depicted in the table below.

Article Date

ROE (%)

17Jul14

5.1

23Sep14

4.0

28Nov14

5.2

Operating Efficiency

As mentioned earlier, operating efficiency is the profit divided by the sales. This in essence tells us how efficiently the company is operating from an operations, financial, and tax perspective. From the table below we see that the profit margin increased by 27.97% for Rowan from the second quarter to the third quarter. We see that net income has increased and sales increased over the period at a smaller clip. Nonetheless, profit margins increased which means the increased in ROE can be attributed greatly to this. In Rowan's case approximately $0.15 are generated in net income for every dollar in sales.

3Q14

2Q14

Change

Average Net Income (TTM)

$66

$49

34.87%

Average Sales

$416

$394

5.39%

Profit Margin

15.82%

12.37%

27.97%

Total Asset Turnover

From the equation I showed above, the total asset turnover ratio is defined by sales divided by assets. Total asset turnover gives us the big picture of how well the company is transforming all of its assets into sales. From the table below we see that the total asset turnover actually remained stagnant from the second quarter to the third quarter. Total revenues increased while average assets increased at a low clip. This portion of the equation tells us that the ROE isn't related to the asset turnover in this particular instance.

3Q14

2Q14

Change

Revenues

$1,662

$1,577

5.39%

Average Assets

$8,602

$8,386

2.58%

Total Asset Turnover

0.19

0.19

2.74%

Equity Multiplier

The equity multiplier is the part of the ROE equation that I don't like. It's with this portion of the equation that a company can choose to get risky or play it safe. It completely depends on how the company manages its debt, equity, and on how well the cash flows are coming in to pay those debts. From the previous portions of the equation we pretty much determined that the ROE has increased thanks to the profit margin increase. An equity multiplier number of 1.72 is pretty good for my taste.

But it isn't until we break it out like I did in the table below that we can see if it is a good thing or a bad thing. As we can see assets have increased and equity has increased at a lower clip, causing the equity multiplier to increase by 0.58%.

3Q14

2Q14

Change

Average Assets

$8,602

$8,386

2.58%

Average Equity

$4,988

$4,903

1.74%

Equity Multiplier

1.72

1.71

0.58%

If we dig a little further we see that the equity value increased by 2.36% primarily because of an increase in retained earnings over the past year, which is always a good sign for me because that's where future dividend increases will come from.

Equity Make-up

3Q14

2Q14

1Q14

4Q13

Common stock

$16

$16

$16

$16

Additional paid-in capital

$1,431

$1,422

$1,413

$1,407

Retained earnings

$3,806

$3,699

$3,679

$3,620

Treasury stock

-$7

-$7

-$10

-$6

Accumulated other comprehensive income

-$135

-$138

-$140

-$142

Total Stockholders' equity

$5,110

$4,992

$4,957

$4,894

In Other News

The offshore drillers have been hammered as of late and that is no surprise as the price of oil just continues to plummet. This is going to be a very tough area to select an investment into the future because there are lots of potential candidates, but Rowan seems to strike me as one of the better opportunities. Between the second and third quarters the company managed to increase its sales, net income and retained earnings, but their total cash has been decreasing. Jeffries continues to believe that now is not the time to buy the offshore drillers, but no one is ever going to be able to pick the bottom and that is why I continue to buy this stock. At least Jeffries and I seem to be in accord with there being some value in Rowan.

Conclusion

The fact that Rowan can increase sales and revenues during the past quarter is pretty astounding, I just have to wait and see how they did in the fourth quarter to make a better case for the buy conviction. But from what I pointed out in this article, not all returns on equity are created equal and in this case Rowan's return on equity is increasing. It is primarily increasing because of higher profit margins. When you multiply all the numbers together you get an ROE of 5.26% which is a 32.25% increase from the prior quarter. This ROE makes Rowan the 29th highest in the Oil & Gas Drilling & Exploration industry (out of 58 companies). I'd like to see Rowan increase its leverage ratio a bit more right now which will eventually increase the ROE but only when the time is right to maybe buy a distressed asset.

Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned. This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!

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.