Royal Dutch Shell Should Acquire Noble Corporation

| About: Royal Dutch (RDS.A)

Summary

Royal Dutch Shell's capital markets presentation shows the company's impressive and growing deepwater ambitions.

The company is Noble Corporation's largest customer and represents more than 60% of its backlog.

The acquisition of Noble Corporation will bring Royal Dutch Shell returns higher than the present returns it expects to get from deepwater drilling overall.

Introduction

Royal Dutch Shell (NYSE: RDS.A) (NYSE: RDS.B) is an Anglo-Dutch multinational oil & gas company headquartered in the Netherlands and incorporated in the United Kingdom. It is the second-largest publicly traded oil company in the world, with a market cap of just under $200 billion, second only to Exxon Mobil (NYSE: XOM) with a market cap of $378 billion.

Noble Corporation (NYSE: NE) is an offshore drilling contractor also incorporated in London, the United Kingdom. It is the successor of the Noble Drilling Corporation and operates by providing drilling rigs to various oil companies in exchange for contracts. However, since Noble Corporation does not have Royal Dutch Shell's oil major status, the company has seen its stock price decimated since the start of the oil crash.

(Source: Royal Dutch Shell Ship - The Times)

Both of these companies have not had a great time since the start of the oil crash. Noble Corporation has watched its stock price drop by almost 80% since the start of the oil crash, and the company now has a market cap of just $2.0 billion. Couple that with its crippling debt load for the downturn, and the company has an enterprise value of $6.8 billion total.

Royal Dutch Shell has fared slightly better since the start of the oil crash. The company has watched its stock price drop by 40% since the start of the oil crash, meaning it has fared twice as well as Noble Corporation. Royal Dutch Shell's debt load as gone up significantly due to the company's acquisition of BG Group for more than $50 billion. The company's present enterprise value is $278.3 billion, of which more than $80 billion is debt.

Acquisition Price

So far, we have an introduction to both Royal Dutch Shell and Noble Corporation, along with an overview of the present value of both companies. For the purposes of investigating this, we will assume that Royal Dutch Shell pays a 25% premium for Noble Corporation, for a total of $8.5 billion. That means should Royal Dutch Shell acquire the company, it will increase its debt by just a hair over 10%.

However, it is likely that Royal Dutch Shell could pay quite a bit less of a premium for an acquisition. While Noble Corporation's stock price has taken an enormous hit, meaning many investors are in the red and do not want to sell at a loss, its long-term potential is also debatable. The company has an immense debt level and a large number of contracts coming off in the coming years, meaning it might be looking to sell itself for a slightly lower premium.

Plenty of Royal Dutch Shell investors are unhappy with its decision to acquire the BG Group in the middle of an oil cycle which has significantly increased the company's debt load. They likely won't be very happy about Royal Dutch Shell increasing its debt load again. However, a 10% increase in the company's debt load is very manageable, changing its debt-to-equity ratio of 40% to 44%. This will not worsen its financial position.

Now that we have a value for the acquisition to start with - $8.5 billion - it is time to discuss the reasoning as to why Royal Dutch Shell should make such an acquisition.

Deepwater Drilling Growth

The reason why the company should make the acquisition are its enormous deepwater drilling goals. We will start by discussing the deepwater drilling goals and then discuss how the acquisition will bring Royal Dutch Shell increased earnings.

(Source: Royal Dutch Shell Deepwater Ambitions - Royal Dutch Shell Capital Markets Presentation)

The above image shows Royal Dutch Shell's future growth goals and capital allocation goals. The company plans on making the deepwater sector as one of its two growth priorities, seeing it as having a 10% ROACE. At the same time, the company forecasts that at $60 Brent, it will spend approximately $15 billion in growth priorities. Of these investments, we can expect that half of them, or $7.5 billion, will be in the deepwater drilling sector.

From this $7.5 billion investment, the company expects it will earn a very respectable 10% ROACE. It is important to keep in mind that this return will compete effectively with the best returns Royal Dutch Shell earned from the 2013-2015 period, when Brent prices were $90 per barrel. At the same time, as a result of this impressive, the company forecasts that its deepwater investments will throw off $5 billion in FCF per annum, a very impressive amount.

(Source: Royal Dutch Shell Deepwater Improvements - Royal Dutch Shell Capital Markets Presentation)

More importantly, these goals are hypothetical goals that Royal Dutch Shell hopes to accomplish under the best case scenario. The company is already making impressive performance in the expensive deepwater drilling sector by cutting its costs. From 2014 to Q1 2016, it has managed to both significantly cut its direct unit operating costs to less than $10 per barrel for most wells, while increasing availability to almost 100%.

Now that we have an overview of Royal Dutch Shell's deepwater drilling plans and cost improvement, let us dive further into the immediate results the company expects to achieve.

(Royal Dutch Shell Deepwater Results - Royal Dutch Shell Capital Markets Presentation)

Royal Dutch Shell's deepwater drilling program has gotten some impressive results which are expected to continue. The company has reduced the breakeven of new projects to a mere $45 per barrel. It is important to keep in mind that this breakeven is lower than present oil prices, which have recovered significantly from their January 2016 lows. In fact, at present oil prices, Royal Dutch Shell deepwater drilling program is pulling a profit.

On top of the rapid decrease in its breakeven prices, the company is expected to see its deepwater production increase rapidly in combination with the BG Group. Royal Dutch Shell expects its deepwater production to more than double, from 400 thousand barrels per day in 2015 to just under 1 million barrels per day in 2020. This means the company's deepwater production is expected to grow by 120 thousand barrels per day annually.

It is important to keep in mind how significant Royal Dutch Shell's deepwater drilling program is expected. The company produces just under 4 million barrels per day of oil. This production growth from the offshore sector from 2015 to 2020 is expected to grow Royal Dutch Shell's production by 15%. Based on its present market cap, the value of this production growth is approximately $30 billion.

To achieve this growth, the company will need deepwater drilling rigs. Now that we understand Royal Dutch Shell's deepwater ambitions, it is now time to discuss how the company can earn more by acquiring Noble Corporation.

Noble Corporation Acquisition Financials

(Source: Noble Corporation Latest Fleet Status - Noble Corporation Investor Relations)

The above image shows Noble Corporation's current fleet status. In exchange for the $8.5 billion acquisition price, Royal Dutch Shell will acquire the company's entire fleet including its existing contracts. Noble Corporation has a total of 30 rigs, of which 7 are currently uncontracted. Royal Dutch Shell could either use these rigs for its current drilling program or sell them away.

Out of the company's current 23 rigs contracted with Royal Dutch Shell, 7 of them are contracted with Royal Dutch Shell and several are undisclosed. Since the company discloses its Royal Dutch Shell contracts, we can assume all of these uncontracted rigs are not with Royal Dutch Shell. Currently, the 7 rigs contracted with Royal Dutch Shell have a total remaining backlog of approximately $3.7 billion.

In fact, Royal Dutch Shell makes up an astounding 63% of Noble Corporation's backlog. That matchup in contracted backlog, which means there will be minimal changes in the process of an acquisition. With any acquisition, corporate culture is incredibly important, and for the majority of Noble Corporation's rigs, nothing will change.

(Source: Noble Corporation EBIT Margin History - Rack CDN)

Noble Corporation's present EBIT margin has been hovering between 25% and 45%. For our purposes, we will assume that the company's margin stays at around 35% for this $3.7 billion of margin. That means if Royal Dutch Shell acquires the company, it receives the margins that Noble Corporation would have made. On this $3.7 billion, that is $1.3 billion of cost savings immediately, or 16% of the acquisition prices.

Beyond this, Royal Dutch Shell's total backlog is $6.9 billion. That means there is another $3.2 billion in backlog contracted to other companies. At a 35% margin, we will assume Royal Dutch Shell takes the profits from these companies and does not recontract them to out to new ones. That means the remaining revenue will bring the company $1.1 billion in profits.

So where are we? In a few years, as all the rigs run out of contracts and are no longer recontracted, Royal Dutch Shell has earned $2.4 billion in profits and has 30 offshore drilling rigs. The company has showed an interest in operating a significant portion of these rigs. That means we know that for 33% of these rigs, Royal Dutch Shell already has a purpose it is using them for.

The $2.4 billion in profits eats up 30% of the company's acquisition costs. So what are the theoretical maximum profits?

Assuming all 30 rigs are contracted out and put to use, that means the total dayrate of all 30 rigs together would be approximately $9 million per day. Should Royal Dutch Shell save all the costs from using these rigs, that means the company would be saving $3.1 million per day. At that amount of savings, the company would earn back its entire acquisition costs back in a mere 5.4 years. That represents 18.5% annual returns - better than any of Royal Dutch Shell's proposed expansion projects.

Assuming the company continues using the 33% of the rigs that it has been as a low point, that is a payback time of 16.2 years. It also means an annual return of 6.2%, which is worse than a number of the company's projects, but still not significantly worse than the 10% the company forecasts itself holding from its deepwater projects. More so, this scenario involves the company not using any of the other 20 rigs of the company.

Taking a midpoint, we would get a return of 12.4%, or a return that is almost 25% higher than Royal Dutch Shell expects to be getting from its deepwater drilling program. And that midpoint would still leave the company with 10 rigs that it can either sell for their scrap value or use for any exploration project. The company could also choose to contract out these 10 rigs. Either way, it is understandable that the return would be slightly higher.

Conclusion

Royal Dutch Shell has had a difficult time recently as a result of its decision to acquire the BG Group, significantly increasing the amount of debt the company has. However, despite this, the company could acquire Noble Corporation at a respectable 25% premium, while increasing its debt pile by just 10%.

More importantly, the returns on the acquisition of Noble Corporation would be very respectable for Royal Dutch Shell. A worst-case scenario would give the company a return of just over 6%, while leaving it with 20 unused rigs that could be sold for scrap value or contracted out to competitors.

However, given the value and scale of Royal Dutch Shell's deepwater drilling acquisitions, the company could likely use a large number of these additional rigs. If the company chooses to use just half of the presently unused rigs that it gets, its return would go up to more than 12%. Such a return would still leave the company with 10 unused rigs, while getting it a return 25% more than its present deepwater growth acquisitions.

For these reasons, I think Royal Dutch Shell should take advantage of the downturn to invest in Noble Corporation.

Disclosure: I am/we are long RDS.A, XOM, NE.

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.

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