By The Valuentum Team
Noble (NYSE:NE) has disappointed income investors.
In October 2015, the offshore drilling contractor cut its dividend 60%, even as it stated that returning cash to shareholders through the dividend continues to be an important element of the company's 'long-term value creation goals' and 'cash-allocation strategy.' The company says debt maturities are manageable, but they are quite staggering in aggregate. Total debt stands at ~$4.5 billion, and while capital spending cuts will help, Noble won't be returning to dividend growth for some time. Liquidity as defined by cash and availability under its revolving credit facility is ~$3.2 billion as of the end of 2015.
Though Noble has essentially ripped the Band-Aid off by slashing its dividend payout, the move speaks to a prudent executive suite that is laser-focused on effective capital management through the course of the economic cycle. The company's business remains highly cyclical, but its hefty backlog speaks of some visibility into future performance. Managing expenses and reducing capital spending will be critical to saving what's left of the dividend. Capital expenditures are expected to be $800 million in 2016, down significantly from the levels of previous years, which has averaged ~$1.8 billion.
Investors would have been wary of Noble's dividend far before its October 2015 cut if they had noted the firm's Dividend Cushion ratio, which has never registered a ratio remotely close to safe. The risks associated with Noble's dividend have kept and will keep us firmly on the sidelines. The company currently registers a 6 on the Valuentum Buying Index -- not the worst rating, but not the best either. We continue to keep a watchful eye on shares.
Noble Corp's Investment Considerations
• Noble Corp is a leading offshore drilling contractor for the oil and gas industry. The firm performs contract drilling services with its fleet of nearly 30 mobile offshore drilling units located worldwide. The average age of its fleet is ~8.5 years. Shell, Freeport-McMoRan, Saudi Aramco, and Anadarko are top customers.
• Noble generates more than one third of its business from the Gulf of Mexico as it shifts its portfolio to ultra-deepwater drilling assets. The firm now generates more than 60% of contract drilling revenue from ultra-deepwater assets.
• In June 2015, we had noted that Noble was yielding 8%-10%, and with the risk free rate but a fraction of such a yield, we had highlighted our view that investors were expecting a dividend cut in the near future. The firm's Dividend Cushion ratio was also below 1. Noble cut its dividend 60% in late October that year.
• Noble's ~$7 billion backlog provides some support, though we note Shell accounts for more than 60%, revealing some concentration risk. The firm is expecting contributions of $2.3 billion and $1.5 billion in 2016 and 2017, respectively, from its backlog, which has declined as of late.
• Noble is intensely focused on pursuing cost control initiatives and reducing capital spending to 'shore up' liquidity. As the company navigates difficult industry conditions, monitoring utilization and day rates has become more important than ever.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Noble Corp's 3-year historical return on invested capital (without goodwill) is 7.7%, which is above the estimate of its cost of capital of 7.3%. As such, we assign the firm a ValueCreation™ rating of GOOD.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Noble's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is -2.5 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Noble Corp's free cash flow margin has averaged about -14% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Noble Corp, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about 26% over the same time period.
In 2015, Noble reported cash from operations of nearly $1.8 billion and capital expenditures of ~$423 million, resulting in free cash flow of ~$1.3 billion. This compares very favorably to negative free cash flow generation in the prior year.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Noble Corp is worth $13 per share with a fair value range of $10-$16. Shares are currently trading at ~$9, below the low end of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
We're projecting continued pressure on Noble's revenue over the next few years as major oil producer's budgets remain restricted due to the ongoing rout in crude oil prices. The firm's earnings will likely remain weak for multiple years as well. We expect that Noble will continue to conserve cash through lower capital expenditures until crude prices rebound, consistent with recent trends. For example, the firm's average annual capital expenditures from 2011-2014 was $2 billion, and in 2015 it reported only $423 million.
Our model reflects a compound annual revenue growth rate of -9.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.2%. Our model reflects a 5-year projected average operating margin of 23.6%, which is below Noble Corp's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.2% for the next 15 years and 3% in perpetuity. For Noble Corp, we use a 7.3% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $13 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Noble Corp. We think the firm is attractive below $10 per share (the green line), but quite expensive above $16 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Noble Corp's fair value at this point in time to be about $13 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Noble Corp's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $15 per share in Year 3 represents our existing fair value per share of $13 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.